Framing Expectations and Achieving Results — April 2016

This topic concerns budgeting.

The budget is a financial expression of the firm’s operating plan. The operational managers must determine what is necessary for the organization to achieve its strategic goals, which are set by owners or executives. An effective budget will express the goals and required resources in target numbers and will show how well the strategy is implemented or if the strategy is even viable.

Traditional budgeting utilizes a bottoms up approach where internal based data is set to budget targets developed at the business unit level. The targets emphasize financial results and substantial general ledger detail. While an adequate approach, we believe there is a more effective approach.

We are proponents of a budgeting paradigm that utilizes a top-down approach that uses external based data to help set budget targets. There is a focus on financial results as well as strategic performance. An 80/20 rule is applied to the amount of detail required.

Budget development involves both corporate and operational managers. For small businesses, corporate means the owner or CEO; operational managers are heads of various profit centers, such as stores, products lines, or branch locations. In our view, the owner articulates the goals of the company and engages in a conversation with operational managers about whether expectations are realistic. The conversation includes evaluation of market drivers in addition to factors specific to the company. Once agreement is reached, operating managers discuss the targets with relevant personnel and request specific action plans and the necessary resources to achieve the targets that have been developed.

The next step entails defining business performance. The key reason for creating the budget is to identify the necessary performance criterion to meet business expectations. The budget is a critical tool that provides management the most effective guidelines to meeting business performance expectations and strategic goals. In addition, managers must define the challenges it must overcome in its endeavors to meet business expectations.

These expectations are defined by the owner in terms of strategic goals. Owners and managers determine the operating metrics and resultant financial measures that indicate the firm has achieved its strategic goals.

Accomplishing this is a multi-faceted, iterative exercise. In essence, the owner defines what must be done, operating managers determine how it will be done and inform the owner. Direction from the top is critical. To have an effective budget, the owner must set targets of what they want to achieve at the corporate level. The parameters are communicated to the operating managers so that they can determine how they can reach the targets that have been set.

When determining budget data against which performance is measured, we are proponents of using the 80/20 rule to avoid becoming bogged down in general ledger line item detail. The underlying rationale is that 80% of business outcomes can be expressed in 20 lines of details Types of reported information might include:

• Revenue by product category
• Operating margins
• Marketing expenses
• Manufacturing costs
• Engineering and Development costs
• Significant Capital Expenditures required for implementation of the strategic plan

Such information is discussed and challenged among owners, managers, and operating personnel to insure that all are in agreement and understand the plans will not be problems for any business unit.

Once these targets are developed, the responsible operating managers decide how to attain them. This entails consideration of external realities like market conditions, competitive environment, and customer needs. Also important are internal factors such as activities employees will pursue during the year, financial resources required, time frame for completion, major milestones, expected returns, and probability of success.

Such an effort produces financial targets, that benchmark financial success in reaching strategic goals. Throughout the year, financial targets are monitored to determine if they have been achieved, how well internal activities have been implemented, and identify significant changes in the external environment. Financial targets include income statement benchmarks for revenues and major cost categories as well ancillary measures including margins, cash flow, revenue growth, asset turnover, leverage, and return on invested capital.

To establish the foregoing targets and augment understanding of why or why not management was successful, business metrics can be utilized to evaluate performance. These metrics measure the effectiveness of executing the strategy to exploit certain business drivers such as new product sales, increased capacity, cost per employee, as well as incremental margins and returns.

The focus is on meeting the targets set for such drivers and determining whether or not attaining the targets resulted in meeting financial projections. The managers must understand how the financial results were achieved and what caused these results to meet, exceed, or fall short of the financial aspects of the budget. If the latter, corrective action and/or revised targets must be implemented.

Achieving a high level of performance requires effective budgeting to frame corporate strategies, business model objectives, and financial targets. A key to successful achievement of financial targets and business objectives is challenging key managers to meet key metrics that determine financial performance.

The budget is a financial expression of the firm’s operating plan. The operational managers must determine what is necessary for the organization to achieve its strategic goals, which are set by owners or executives. An effective budget will express the goals and required resources in target numbers and will show how well the strategy is implemented or if the strategy is even viable.

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