Budgeting is a complex process, which is becoming increasingly affected by the company’s environment. The complexity and volatility of the market situation means that many organisations cannot cope with the enormity of information and increasingly tend to resort to simplifying the process of creating financial plans. This is how budget deviations – discrepancies between forecasted and actual values – occur.
A common method to minimise budget deviations is applying the controlling procedures and creating budgets that are regularly revised and updated. If these actions are based solely on information about the company and do not include information about the market environment, they will not be fully effective.
Below we give specific tips, useful in the budgeting process. They will help plan the budget so as to minimise unfavourable budget variances.
Use data on the market environment
Most companies create a budget based on documents from previous years, historical parameters, sales plans and purchases. Unfortunately, these methods are based on information coming from inside the organisation. But mind you, the most important thing for the structure of the budget is data on the market environment and the possible directions of the industry’s development in the future.
Examples of data affecting the revenue side of the budget
- Target market – the potential and dynamics of development, identification of barriers to entry, market trends.
- Competitive environment – understood not only as competing entities and products, but also substitute products and the degree of market saturation.
- Distributors – their financial situation, consolidation trends and new players in the area of distribution.
- Customers, consumers, and decision makers in the purchasing processes – behavioural changes in terms of purchasing decisions, preferences, needs, disposable budgets and consumer trends.
Examples of data affecting the cost side of the budget
- Suppliers – changes in terms of consolidation, new entrances, bankruptcy or financial problems in the industry, as well as the cost base and a potential area to negotiate prices.
- The basic goods market – for instance currencies, oil, metals, and agricultural products.
- Administrative and legal environment – changes and planned changes that may either incur additional expenses or level existing costs.
Omitting data on the business environment
No reference to the market situation is the most serious mistake in budgeting. If revenues are planned solely on the basis of the quantity and value of products which we want to launch, and the costs are based only on internal estimates, sooner or later there will be significant budget deviations. It can be the result of, among others, such uncontrollable events as:
- entry of a new competitor, which is likely to hinder sales,
- entry of a new supplier, which opens the possibility to negotiate prices and lower costs,
- consolidation of the competition, which will strengthen the position of the new entity (for example through the effect of scale and the breadth of the offering), but also reduce the number of competitors,
- consolidation of suppliers, which can reduce the bargaining power of customers,
- changes in consumer behaviour (e.g. changes in buying behaviour related to the place and the frequency of shopping, changing preferences resulting from a fashion or trend) – those aspects of consumers will affect not only the value and volume of sales, but also the pricing policy and cost planning.
Define the market, competition and substitutes
A proper definition of the target market has a huge impact on budget planning. It has to take into account not only competing offers, but also substitute products, because substitutes satisfy the same need, but in a different way.
Budget deviations appear when you use:
- too narrow definition – this will result in an underestimation of the market, which could bring an increase in sales, but only under the condition that the company is prepared to increase production,
- too broad definition – your company will face the challenge of a shrunken market (e.g. due to strong competition and a wide range of substitutes), which will be reflected in a reduction in sales and an increase in inventory.
Make use of econometric models
Forecasting data for budgeting is often simplified due to a lack of knowledge, skills or time. And yet, to have a reliable forecast, you need to take into account many different factors and identify the connections between them, accurately predict trends, and apply the tools of econometric modelling.
Let’s analyse – for example – the process of sales forecasting and budget deviations deriving from methodological simplifications:
- A forecast on the basis of the estimated changes in inflation. You can apply this approach by making the assumption that the price of products will grow at the same rate as the average increase in prices in the economy. But this will be affected by a fundamental error, because some industries (including modern technologies) record very weak connections with the general changes in the economy. With this method budget deviation will therefore occur very often.
- A forecast on the basis of estimated GDP changes. This is a better way than the use of inflation forecasts, but even linking sales with GDP will not eliminate budgetary slippages. We still aren’t taking into account other key aspects, such as for example the situation in international markets.
- An econometric model takes into account key factors: inflation, GDP and oil prices. The risk of budget deviation in such an approach is much more limited. Unfortunately, this happens at the expense of increasing the level of complexity of the analytical process. There is a need to analyse the connection between all the variables and the inclusion of different types of changes in the institutional environment (e.g. transportation cost depending on the change in the number of permits for the transport of goods).
Collaborate with other departments
Many budget deviations stem from a lack of cooperation between the department dealing with forecasts and the department that collects data about the market. So it is worth to ensure a smooth and constant communication between the two. As a result, the analyst responsible for preparing forecasts will have all of the key information about the market. A good understanding of the business environment and the industry translate into a better budget.
Learn the methodology of data preparation
When data for the budget is developed within the company, it is usually well documented, intelligible and consistent. But in the case of data acquired from outside sources, you cannot be sure that it is well prepared and that it will be useful.
To protect yourself from analytical errors, budgetary deviations and incorrect conclusions, you need to know exactly how external data is prepared. This means understanding how it is obtained and assembled, and what are all the specific methodological conditions. If necessary, you should also harmonise external data with internal data.
Develop a simulation of potential budget deviations
It is hard to imagine a budget that will not have any deviations whatsoever. And since we accept the appearance of deviations, we might as well prepare for them. Timely identification of their type and size will allow both to introduce modifications to the budget, and to implement scenario planning in the event of the occurrence of deviations in the future.
Take advantage of expert knowledge
Budgeting should be carried out on the basis of both company data and market environment data. More and more organisations are realising this need, but they don’t always have the necessary powers and tools. So companies acquire market analysis from external entities specialised in providing this type of information. Such partial outsourcing of the budgeting process has several advantages:
- the knowledge of an external, impartial expert,
- an external perspective to the analysis,
- the use of modelling methods, taking into account many key factors,
- access to professional tools for econometric modelling,
- verification and harmonisation of data collected by the company.
A model that combines internal knowledge and external support can seem convoluted and expensive. However, in the long run it will bring many benefits, because it will:
- reduce inefficiency in allocating resources,
- reduce business risk,
- identify opportunities and threats more quickly and take them into account in plans and budgets,
- provide knowledge about the market environment for employees at various levels of the organisation.