Reading Financial Reports for Dummies (36 page)

No matter how good the numbers look, you don’t know how well a company is really doing until you compare the actual numbers with the company’s expectations.
Expectations
(the budget targets a company hopes to meet) are spelled out during the
budgeting process,
in which the company projects its financial needs for the next year. At different times throughout the year, these budgets are used, along with periodic financial reports, by managers looking to determine how close the company is to meeting its budget targets.

As an outsider, you don’t have access to the company’s budgets or the reports related to them. But for those of you seeking to find out more about internal financial reports and how to use them effectively, understanding the budgeting process is critical.

This chapter discusses the budgeting process and how it complements financial reporting. A well-planned budgeting process not only helps a company plan for the next year but also provides managers with key information throughout the year to be sure the company is meeting its goals and raising red flags when it doesn’t reach its goals. The sooner managers recognize a problem, the greater their ability is to fix it before the end of the year.

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Peering into the Budgeting Process

The budget that a company sets for itself relies on a lot of careful calculations and some guesswork about the amount of revenue it expects from the sale of products and services, as well as the expenses it will incur to manufacture or purchase the products it sells and to cover the other operating expenses during the next year. Creating a budget is a lot more complicated than just making a list of expected revenues and expenses. I talk more about the basics of revenue and expenses in Chapters 4 and 7.

Companies use one of two approaches to budgeting:

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Top down approach:
Key executives set budgets and give them to department heads to meet. Most employees aren’t involved in the budgeting process; instead, those at the top impose the numbers on the employees, who are expected to meet them. The big problem with this type of budget process is that the employees don’t feel any ownership of the budget and frequently complain that the budget handed down to them is unrealistic, which is why they can’t meet expectations.

Few large corporations use the top down approach today. You’re more likely to find this approach in small businesses run by one person or a small group of partners.

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Bottom up approach:
Budgets are created at the department level based on overall companywide goals and guidelines that the board of directors and top executives set. This approach encourages employee participation in the budgeting process, so the employees have more of a sense of budget ownership. Because they help develop the budget, they can’t later claim that the budget is unrealistic if it turns out that they don’t meet expectations.

Most management studies show that the bottom up approach works better because managers and staff members are more likely to take a budget seriously and follow it if they have some involvement in developing it. In this chapter, I focus on the process for bottom up budget development, which is the most commonly used budgeting process in large corporations today.

Who does what

Everyone has a role to play in bottom up budgeting. Top executives who are part of a budget committee set companywide goals and objectives. Then, starting at the lowest staff levels, each department determines its budget needs. These budgets work their way through the management tree to the top, where numbers from each department are pulled together to develop a companywide budget.

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The budget committee manages the entire process and is responsible for determining budget policies and coordinating budget preparation among departments. Most often, this committee includes the president; chief financial officer (CFO); controller; and vice presidents of various functions, such as marketing, sales, production, and purchasing.

Even before the departments start to develop their budgets, the budget committee develops rules that all departments must follow. These rules likely include a request to hold all budgets to a certain percentage increase in costs, and possibly even a reduction in costs. These guidelines help departments develop budgets that meet company needs while proposing something the departments can live with through the year.

The budget committee doesn’t mandate what the department’s actual budget should be or how the department should find a way to keep its costs down; those decisions are left to each individual department. One department may decide it can cut costs by reducing staff; another may determine to cut costs by getting better control of the use of supplies; another may decide that cutting back on the use of rental equipment or temporary help can meet its cost-cutting goals. By leaving these choices to the departments rather than mandating the numbers from the top, companies give employees a stake in meeting their budget goals.

After the budgets are developed at the section and department levels, the budget committee gives final approval for all budgets. The committee also resolves any disputes that may arise in the budget process. Budget disputes can occur when different departments have conflicting goals to meet.

For example, say the manufacturing department is mandated to cut costs, while the sales department must increase sales to meet its goals. The manufacturing manager may make a decision to cut costs in a way that lowers product-quality standards. However, the sales manager may believe that this cost-cutting method will create problems in maintaining customer satisfaction and ultimately hurt sales. The budget committee acts as the mediator for this kind of decision-making process.

Setting goals

To develop companywide budget guidelines, the budget committee must first determine the goals for the company. Before they can set those goals, they gather information about where the company stands financially, how the company fits into the bigger economic picture, and how it stacks up against its competitors. This information forms the basis for what the committee determines it needs to accomplish during the next year, such as increasing market share, increasing profit, or entering a new market area completely.

Sections and departments can then estimate the resources they need to meet those goals.

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The first critical step for goal setting is to develop a
sales forecast
(a projection of the number of sales the company will make during the year), usually involving the staff of several departments, including marketing, sales, and finance. Much of the data collected by this staff is from industry research reports as well as from actual company numbers from the accounting, finance, and marketing departments.

Factors that must be considered to develop an accurate sales forecast include

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Past sales success:
By looking at a breakdown of sales by product for the past three to five years, a company can look for trends and make a best guess about future sales growth potential.

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Potential pricing policy:
By looking at past sales, a company can determine if the current pricing policy is viable or if changes are needed.

Products that are moving quickly off the shelves may be able to sustain a price increase, while those that aren’t moving may need a price cut to stimulate sales. Pricing isn’t set solely by sales success or failure, of course; costs for producing the product are a key factor as well.

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Data about unfilled orders and backlogs:
This data helps a company determine which product lines may need to be modified to meet demand.

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Market research:
This research includes potential sales and competitive data for the entire industry, as well as forecasts for the individual company. This information lets the committee know where the company fits in the industry and what potential the industry may have in the next year.

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Information about general economic conditions:
This research gives the budget committee an overview of expected economic conditions for the next year so they know whether there’s potential for growth or a possible reduction in sales. For example, if the economy has seen a slowdown during the past three years but economists are now predict-ing a market recovery, the company may need to increase manufacturing goals to meet anticipated increasing demand.

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Industry economic conditions:
A company monitors these conditions to determine whether the industry in which it operates is set for a growth spurt, a downturn, or is expected to perform at the same level in the next year.

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Industry competition data:
Reviews of competitors’ marketing strategies, advertising, and other competitive factors must also be considered when developing future goals in order to stay competitive within the industry. This information must be reviewed to determine where the company sits in relation to its competitors and whether new competitors are on the horizon that could challenge the company’s products.

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Market share data:
A company collects this data, which is the percentage of the market held by the company’s products, to help set goals —

whether to increase market share or maintain current levels. Growth potential depends on increasing market share, but if the company already holds nearly 100 percent of the market, like Microsoft does in the operating systems market for personal computers, room for growth may not exist. In that case, marketing strategists focus on tactics for maintaining that market share.

In addition to the hard numbers, a company collects information from staff members at all levels to get a firsthand view of what’s actually happening in the field. This information includes reports about exchanges with customers, vendors, and contractors. Real-world data that a company collects from sales staff, customer service staff, purchasers, and other employees gives the company additional information and allows it to test the numbers.

Building Budgets

After the budget committee finishes data collection (see the preceding section), it can determine sales goals for the company. After the committee establishes goals, it uses them to develop
strategies
— the actual methods used to reach the goals — and build budgets that reflect the resources needed to carry out the strategies. Although the budget committee sets companywide goals and global strategies, each section and department translates those broad goals and strategies into specific goals and strategies for its own staff.

Armed with its goals and strategies, each department develops its specific budget. Not all departments develop their budgets at exactly the same time, because some departments depend on others to make budget decisions. For example, sales revenue must be projected before the company can make decisions about production levels and just about every other aspect of its operations.

Common budget categories include the following, which I organize according to the order in which they’re produced:

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Sales budget:
Sales managers start their budget planning by forecast-ing sales levels and the gross revenue they anticipate those levels will generate. Most other budgets depend on the goals set by sales, so this budget is usually the first to be developed. Without a sales budget, production managers don’t know how many products to produce, and purchasing managers don’t know how many items to buy.

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Production budget:
If the company manufactures its own product, then this is the next budget to be developed. The production department looks at the beginning inventory left from the previous planning period and plans what additional inventory is needed, based in part on the forecasts in the sales budget. Production planning can be a difficult development task. Making sure they have a just-right level of inventory means that production managers must be sure they plan for the right amount of raw materials, the efficient use of production facilities, and an appropriate number of staff members to produce the products to meet customer needs on time.

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Inventory purchases budget:
For companies that don’t manufacture their own products, the budgeting process focuses on purchasing needed inventory and being sure it’s delivered on time to meet customer needs. Similar issues drive purchasing concerns because a company wants to be sure it has enough product on hand to meet customer demand. But at the same time, it doesn’t want too many products left over, because that means resources were wasted on inventory and could have been better used to meet other company needs.

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Direct materials budget:
This budget controls the raw materials needed to meet the production schedule. The last problem any company wants to face is not having enough materials on hand to keep the product line moving, thus risking a factory shutdown. But the company also wants to avoid keeping too many materials on hand, because doing so increases warehousing expenses. Also, holding raw materials too long can result in material spoilage.

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Direct labor budget:
This budget is unique to manufacturing companies and is dependent on the production budget. Companies work hard to determine how much staff they need to meet production needs. If they hire too few people, they have to deal with overtime charges, or in the worst cases, they face production shortfalls. If companies hire too many people, they may end up spending more than necessary on salaries or have to lay off employees — which is a huge blow to morale.

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Selling and administrative expense budgets:
Many smaller departments are involved in getting a product to market and supporting those sales. These departments include accounting, finance, marketing, human resources, mailroom, and materials management. After sales revenue is known and the cost of selling those goods has been determined, the remaining resources are divided up between the company’s selling and administrative needs.