Budgeting for Analysis

Author: Larry Chester

Nobody likes creating a budget. If it’s done correctly, it’s a lot of time-consuming, hard work. But budgeting is vital because it’s the company’s plan for the coming year. No plan can be created without good, reliable data and analysis. If the proper analysis is done, then the budget becomes a tool to guide the company forward.

Bring Value through CFO Insights:

Like any forecasting tool, proper budgeting allows management to make decisions that can help the company avoid future problems. Budgeting is a process that may result in multiple iterations before the resulting numbers are acceptable. The secret to proper budgeting is twofold:

Accurate source data allows the creation of a realistic budget.

A management plan based on that budget to achieve the desired result.

• Business – CNC Machine Shop
• Location – West suburban, Chicago, Illinois
• Sales – $25,500,000
• Ownership – Sole owner (with son actively involved)

Initial Contact –

The owner started the business 35 years ago. Even though the son was eager to take over, the father wasn’t ready to let go yet. The son realized that they needed to do more planning, including a much-needed budget. Their in-house CFO was too busy to take on the task.

Significant Findings and Recommendations:

Create a New Budget

A detailed set of reports, complete with sales and costs by item group created a good starting point. The company had seven different revenue streams. In addition, the owner was heavily into developing prototype parts for aerospace companies on a speculative basis. These parts were produced as a favor, in the hope of getting big contracts that had yet to materialize.

Recommendations

• Produce a set of trend-line reports for each item group for the past three years of sales. Then extend that trend-line till it shows the estimate of next year’s sales.
• Examine the manufacturing variances over the past year to identify any continuing variances that might require a change in process to improve performance
• Include additional expenses related to speculative promotional programs involving samples for new programs.
• Determine seasonality by charting monthly sales for each product group.
• Chart payroll by the department and by month. Plan for any changes in staffing for the coming year – new hires and terminations.
• Draft a list of overhead expenses, including utilities, rent, leases, service contracts, and loans.
• Create an initial budget for evaluation.

Evaluation

The initial draft of the budget projected a year-end loss of over $3.3 million. Discussions with the owner provided an explanation. His plan projected a significant improvement in sales. Without a plan to bring those sales forecasts to fruition, the projected loss would indeed become a reality. The analytical approach to budgeting created a new opportunity to put hard thought behind business changes:

• Sales in some product groups projected an increase as the result of improved sales efforts.
• Salary freezes, and/or temporary reductions in pay reduced payroll expense.
• Lay-offs (i.e., reducing manufacturing staff to skeleton crews).
• Ending development of speculative projects eliminated that ongoing expense.
• Exploring additional sources of revenue – doing subcontracting work – (e.g., bringing in work from other companies).

The company faced a deepening cash shortage

The budgeting process laid bare the issues the company had been facing but management had been ignoring. The use of the operating line had been increasing. The owner loaned additional money to the company to shore up cash needs.

Recommendations

• Develop a cash flow forecast. This projected an increasing shortfall over the next six months. Planning allowed the company to identify specific areas in which they could extend payments or delay purchases until the new sales activity produced results.
• Improve cash visibility by instituting a daily cash report showing the ins and outs of company operations. Projections aren’t enough when you’re running short. It’s important to look at cash daily to assure that you don’t overextend your availability.

Financial reporting was erratic

Monthly reports showed inconsistent results, making it difficult for management to make decisions that had a positive impact on company results. Changes in standard entries and more careful posting of expenses and revenues would smooth out reporting inconsistencies.

Recommendations

• Depreciation entries should be made monthly, rather than at year-end. This spreads those adjustments throughout the year, and eliminates massive adjustments at year-end, providing more accurate monthly reports.
• Institute accrual basis accounting, which posts certain expenses monthly as they apply to the business. Payments for insurance, marketing, trade shows, and travel should be spread over 12 months to allow for a more accurate presentation of monthly results.
• Posting Expenses. Costs should be posted to inventory for the purchase of raw materials, rather than being expensed. Outside service expenses should be posted in the month in which they occur. Posting them in the same period as revenue avoids huge swings in profitability that were not easily understood, in addition to obscuring true operating results.

Although a budget won’t change the way your company runs, it may well change the way you manage it. In this case study, the owner’s sales projections for next year were significantly different from the trend-line analysis. In addition, he felt the continued efforts to deliver speculative prototypes were fully supported by the earnings of the company—and worth the risk. Unfortunately, the company’s sales had been declining in five of the company’s seven product lines over the past 4 years, and the expectation for a dramatic turnaround was unlikely. Without the detailed analysis that led to this budget, the company would have spent the next year digging an even-deeper hole in the cash available to run the business.

It is data – information – that provides the window through which a business should be viewed. Many business owners have good instincts—solid gut feelings about the decisions they make for their company. But digging into available data provides a window into the details of how the company operates. Rather than only looking at the results, examining where the data originates and how it has changed can shed new light on future planning.