Preparing and Implementing a Traditional Budget

Projecting Future Income From Past Performance

Preparing and Implementing a Traditional Budget - Projecting Future Income From Past Performance

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Traditional budgeting is all about getting your finances in order.

In many organizations, it's common to base future plans on what has worked well in the past. You may even do this yourself.

For example, you may have developed checklists to carry what you've learned from piece of work to the next, or you may have based a new project on one that was previously successful.

This concept can also be used when preparing budgets. When it's applied formally, this is known as traditional budgeting, because it's a well-established method of forecasting costs and income.

A traditional budget is based on the previous year's figures. However, these figures are updated to include the new year's predicted sales, changed costs, and additional, relevant information that has been gathered since the last budget. In this article, we'll look at traditional budgets in more detail. We'll also outline how to set them up, and how to manage them.

About Budgeting

Budgets are used to outline an organization's financial goals for a set period (typically a year). People then use the budget to monitor progress, by comparing actual performance against projected results.

However, budgets have another essential function: they're one of the key ways in which power is devolved within an organization. They give managers the flexibility to run things their way – within reason – provided that they meet their agreed budget.

As such, if you're preparing a budget, it's essential that you have a clear understanding of how you plan to achieve the targets that you've set yourself and your team.

Why Use a Traditional Budget?

When you prepare and manage a traditional budget, you can do the following:

  • Plan the year ahead, using proven data and existing knowledge. You can use past income and cost figures, along with knowledge of your products and market, to generate sensible projections of income and costs for the following year.
  • Monitor performance. When you compare current performance with that of previous years, and you factor in changing market conditions and other issues that affect your team, you will have an "at a glance" measure of year-on-year progress.
  • Check assumptions. When you look back over previous years' income and cost figures, you can identify trends that could affect future income. You can then adjust your projections to take these issues into account, ensuring that your plans are workable.
  • Spot opportunities for savings. When you compare existing costs with planned ones, you may be able to identify opportunities for cutting or spreading costs.
  • Allocate resources. As part of the detailed thinking that goes into preparing a traditional budget, you'll need to think about what projects you will and won't run to meet organizational goals.

Flaws of Traditional Budgets

Traditional budgets are well established in many organizations, but they do have some disadvantages. For example:

  • They can take a long time to prepare, monitor, and adjust. This means that an organization may not approve its budget until it's well into its budgetary period.
  • They are often reactive rather than proactive. In addition, the effort involved in traditional budgeting means that people may be hesitant to modify the document, even when it has become unrealistic.
  • They may perpetuate poor decisions made in the past. As they're based on the previous year's budget and performance, it's possible that mistakes and unwise spending allocations can be carried over into the new period.
  • They can also make it hard for innovation and creativity to flourish. There's a tendency for the bulk of the budget to be allocated along the same lines each year, even if there is a strong business case for new ideas.

Note 1:

We use the term "traditional budget" in this article to differentiate this approach from zero-based budgeting (also known as zero-base budgeting).

A zero-based budget is not based on previous performance, but is set up fresh at the start of a new accounting period. As part of this, managers must examine each source of income and expense with fresh eyes.

Zero-based budgets can take a particularly long time to prepare. They are most common in start-up businesses.

Note 2:

Because of the time and effort involved with the traditional budgeting process, some management strategists suggest using rolling budgets.

Initially, these are prepared for a one- to three-year horizon. They are then updated regularly – usually every quarter or month. This keeps the current budget document relevant, and allows the organization to adapt to any changes.

Read our article "Words Used in Corporate Finance" to learn more about different budgeting terms.

How to Use Traditional Budgets

Let's look at how you can set up and use a traditional budget to monitor financial performance.

1. Align the Budget With Your Organization's Strategy

Typically, the budgeting process is initiated at a high level, as part of an organization's strategic planning process. At the end of the strategic planning process, executives will go firm on sales and profit projections, economic forecasts, and other assumptions that will affect revenue and expenses.

When these have been agreed, you can use them to prepare a budget for the next period, typically the following year. Where the strategy is essentially similar to that of the previous year (with small modifications) it makes sense to use a traditional budget – otherwise you may need to start from first principles with a zero-based budget.

2. Update Last Year's Figures

Start by looking at last year's budget. Then, adjust each line item based on the changes that you expect to see in the coming year.

With the organization's strategy in mind, think about the following:

  • What do you anticipate revenue to be this year?
  • Do you need to spend more on marketing or commissions to achieve these sales figures?
  • Are you expanding into new territory? What are the expenses associated with this?
  • Do you need to provide cost-of-living wage adjustments, or implement pay-related union agreements?
  • Are utility or raw material costs increasing or reducing?
  • Are there any other factors that you expect to vary, or that you need to include or eliminate?

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3. Factor in New Initiatives

Now add new items to the budget based on the goals and needs for the period.

  • Will you need to purchase new equipment?
  • Will you hire additional staff?
  • Are you adding a new product or service?
  • Are you undertaking any major projects this year that will require additional resources?
  • Alternatively, do you plan to cut projects or eliminate activities?

4. Negotiate the Budget

Once you've submitted your desired budget, you should expect it to be challenged. After all, desired budgets are often "ambitious," and costs need to kept under control if the organization is to make a reasonable profit.

This process may involve significant negotiation, as there are likely to be many competing demands for a limited pot of money. Be prepared to make a strong business case for your budget, and to outline the ways in which it contributes to the organization's strategy.

5. Implement the Budget

After the final budget is approved, you can use it to track actual results against your predictions.

At regular points throughout the year, you'll need to analyze your budget and calculate variances – in many organizations, you'll be prompted to do this via a periodic performance variation report. This helps you think about how you will bring your expenses in line with your budget.

If there are changes that you hadn't expected, you need to take appropriate action to get things back on track. You may also need to adjust the budget so that it reflects the new situation – and how you plan to respond to it – more accurately. Don't expect this to be pleasant, easy or unchallenged, however: this may cause the entire organization to miss its earnings targets, and you can expect a lot of unwelcome attention as a result.

For example, imagine that one of your suppliers suffers a serious setback. They won't be able to deliver your order on time – in fact, it will arrive three months late. You'll lose many of the sales that you'd predicted for this period, and the delay may have knock-on effects, too. For example, you could lose customers, or you may need to allocate extra resources to process the order quickly when it arrives.

Your first actions would be to find an alternative supplier or product. You'll then need to predict how this situation will affect your operations, and to draft a new budget that might include a temporary layoff.

Example

PQR Plumbing Supply has created a traditional budget based on its figures from the previous year. The example below shows its budgeted figures, actual figures, and variance figures.

As you can see, the company met the sales target that had been set in the budget. However, many costs were higher than predicted, which means that the company's overall profit was not as high as might have been expected.

Budget for PQR Plumbing Supply
Item Budgeted Actual Variance
Net Sales
$780,000
$802,000
$22,000
 
Expenses
Materials
$356,000
$364,000
$8,000
Labor
$185,000
$184,000
($1,000)
Supplies
$23,000
$24,650
$1,650
Salaries
$45,000
$45,000
$0
Rent and Utilities
$49,200
$49,875
$675
Travel
$2,000
$3,180
$1,180
Commissions
$62,400
$64,960
$2,560
Interest
$1,750
$1,750
$0
Total Expenses
$724,350
$737,415
$13,065
 
Operating Profit
$55,650
$64,585
$8,935

Key Points

A traditional budget is a financial planning document that you can use to express financial goals in quantifiable terms.

It's based on the income and costs of the previous year. However, you amend it to account for continuing trends, updated sales figures, and changes that you'll need to make in the forthcoming year.

You can use it as a way to measure financial performance, and to plan how to respond to unexpected changes.

A traditional budget can take a significant amount of time to prepare and agree upon. Its lack of flexibility can also stifle flexibility and "lock in" poor decisions from previous years.

However, traditional budgets remain a staple in many organizations. They help managers make informed decisions about resources and planned work, and they help senior executives manage the wider organization.