Magazine article Management Review

Budgeting; Planning for the Unknown

Magazine article Management Review

Budgeting; Planning for the Unknown

Article excerpt

Few managers, from president down to the lowest level, are satisfied with their budgets. What might be a tool for better planning and management often becomes a work of fiction only a few months into the few fiscal year.

Perhaps the two greatest problems managers face in budgeting are the uncertainty of the future and the uncontrollability of important outside factors that can significantly affect the corporation's destiny. These problems are inherent in every budgeting process and no amount of number crunching will alleviate them. In fact, when budgets are made up indiscriminately of items that management can control as well as items that are beyond its control, it becomes impossible to tell whether management is doing a good job or is just plain lucky. Companies need a technique that recognizes and deals head on with the inherent uncertainty and uncontrollability. The assumptions process is that technique.

The essence of the assumptions process is to make explicit suppositions, as part of budgeting, about every outside environmental factor - or OEF - that is important to the company. Briefly, the idea is to identify all the important OEFs that will affect the following year; make the best assumption possible about each of these OEF; develop the budget numbers based on these assumptions; review these assumptions over the course of the year; and change the budget when it becomes clear that the assumptions are no longer accurate.

For instance, if a company has a substantial subsidiary in Japan, one of its important OEFs, then, is the yen-dollar relationship. Accounting rules require that the balance sheet be continually revalued in dollars; the value of a balance sheet denominated in yen depends on whether the yen falls or rises against the dollar generating profits or losses completely outside the control of the company.

It is appropriate to handle the yen-dollar relationship with a budgetary assumption regarding the average exchange rate for that year. The portion of budgeted profit or loss resulting from currency fluctuation is simply based on this assumption. Any time during the year that there is a large move in the yen versus the dollar, the assumption is invalidated and a new one adjusted accordingly.

How would this have been handled without the assumptions process? The predicted profit and balance sheet figures of the Japanese subsidiary cannot be put into the budget without an assumption about the yen-dollar rate for the coming year. Typically, however, this assumption is implicit. Currency profit or loss is then just part of the subsidiary profit budget that management is expected to meet.

If during the year, the yen-dollar rate is quite different from the assumption (which is probable), management either gets a windfall or has a problem not of its own making. In the latter case, there will be pressure to cut some planned, productive activity to get back on budget. In short, the company will be influenced to spend less or more, and management will be rewarded or punished, for an event that has no bearing on how well the subsidiary performs. A good strategy may be crippled by cost cuts brought on totally by the outcome of this OEF.

Benefits of Assumptions Process

This example illustrates a number of important benefits of the assumptions process as a budgeting tool. It focuses management and the board of directors on the outside factors that effect the company but are beyond its control. It makes the budget more realistic because uncertainty and uncontrollability are explicitly recognized. The process also reduces the resulting psychological games of budgeting, which usually revolve around future uncertainty and OEF. There's also less motivation for hidden "pads" in budgets, and "honest best" submissions are encouraged. It makes measurement realistic and fair. It sends an uplifting message to the organization that top management and the board understand the problems, and it helps all levels understand the company's critical factors for success. …

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