Conditional budgeting

Conditional budgeting is a budgeting approach designed for companies with fluctuating income, high fixed costs or income depending on sunk costs, as well as NPOs and NGOs. The approach builds on the strengths of proven budgeting approaches, leverages the respective advantages for situations of fluctuating incomes, and at the same time reduces possible negative impacts.

Summary

The core idea of conditional budgeting is to structure income and expenditures according to probabilities and priorities respectively. After the budget is approved, the actual status of the finances is reviewed and analyzed regularly, and if income reaches a certain level (or probability), the corresponding level of expenses is approved.

Therefore, conditional budgeting does not focus on spending a certain amount of money or consuming certain resources; rather, it defines priorities of expenses and resources as well as income and earning levels that will allow releasing the funds for expenses and resource consumption.

Background

While different understandings of budgeting exist, for the purpose of this article budgeting shall be understood as the implementation of the long-term plan for the year ahead. Because of the shorter planning horizon budgets are more precise and detailed. Budgets are a clear indication of what is expected to be achieved during the budget period whereas long-term plans represent the broad directions that are intended to be followed.^[1]

Traditional line item budgeting

The traditional budgeting approach develops a plan within the context of ongoing business and it is ruled by previous decisions that have been taken within the long-term planning process.^[1] Budgeting may serve different functions such as: forcing managers to plan ahead and therewith reducing ad hoc decisions; communicating objectives, perceived problems, and opportunities, as well as the role that everyone is expected to play; coordinating the separate activities and ensuring that all parts of the organization are in mutual harmony; aiding motivation through setting targets and providing a challenge; or providing standards which can be employed as part of the control process.^[2] To establish a budget, Smith suggests the following six steps:^[3]

• communicating details of budget policy and guidelines to those people responsible for the preparation of budgets
• determining the factor that restricts output
• preparation of the sales budget
• initial preparation of various budgets
• final acceptance of budgets
• monitoring of actual results against the budget.

The traditional budgeting approach, also called a line-item budget, normally consists of a set of several budgets that build on one another and have to be integrated. For a manufacturing company, these budgets may be:^[4]

• sales budget
• production budget
• direct materials usage budget
• direct materials purchase budget
• direct labor budget
• factory overhead budget
• selling and administration budget
• cash budget.

This approach typically builds on the previous year's sales and cost structure and it works fine for unit-level costs where the consumption of resources varies proportionately with the volume of the final output of products or services. Such approaches are also called incremental budgeting.^[5]

Activity-based budgeting (ABB)

While basing the budget on previous effective cost figures, and therewith accepting the cost of non-unit level activities to be fixed, and consequently inherent past inefficiencies and waste in the current way of doing things, activity-based budgeting allows managing costs more effectively. Adopting the underlying ideas of activity-based costing (ABC), ABB authorizes the supply of only those resources that are needed to perform activities required to meet the budgeted production and sales volume. In this budgeting process, cost objects are the starting point and their budgeted output determines the necessary activities which are then used to estimate the resources that are required for the budget period. The process stages are:^[5]

• estimate the production and sales volume by individual products and customers
• estimate the demand for organizational activities
• determine the resources that are required to perform organizational activities
• estimate for each resource the quantity that must be supplied to meet the demand
• take actions to adjust the capacity of resources to match the projected supply.

Zero-based budgeting (ZBB)

Zero-based budgeting, also known as priority-based budgeting, emerged in the late 1960s as an attempt to overcome the limitations of incremental budgets.- This approach requires that all activities are justified and prioritized before decisions are taken relating to the number of resources allocated to each activity. ZBB typically also focuses on activities instead of functional departments.^[6] Zero-based budgeting involves the following three stages:^[7]

• description of each organizational activity in a decisions package
• evaluation and ranking of decision packages in order or priority
• allocation of resources based on the order of priority up to the spending cut-off level.

Criticism of budgeting

The major criticism of the traditional annual budgeting approach is that the process is incapable of meeting the demands of the competitive environment in the Information Age. The specific criticism points are:^[8]

• encouraging rigid planning and incremental thinking
• being time-consuming
• producing inadequate variance reports leaving the 'how' and 'why' questions unanswered
• ignoring key drivers of shareholder value by focusing too much attention on short-term financial numbers
• being a yearly rigid ritual
• tying the company to a 12-month commitment, which is risky since it is based on uncertain forecasts
• meeting only the lowest targets and not attempting to beat the targets
• spending what is in the budget even if it is not necessary to guard against next year's budget being reduced
• achieving the budget even if this results in undesirable actions.

Steven Bragg adds that the typical budget process requires a large number of iterations and many meetings by the management team before a satisfactory budget is created. This is not an efficient use of managers' time, since they must meet many times to make incremental changes to the budget and then wait for the budget team to process the changes and give the results back to them.^[9] Jack Welch, the former CEO of General Electrics, concludes that the budgeting process at most companies has to be the most ineffective practice in management. It sucks the energy, time, fun, and big dreams out of an organization. It hides opportunity and stunts growth. It brings out the most unproductive behaviors in an organization, from sandbagging to settle for mediocrity. In fact, when companies win, in most cases it is despite their budgets, not because of them.^[10] Jack Welch instead imagines a system of budgeting where both the field and headquarters have a shared goal: to use the budgeting process to ferret out every possible opportunity for growth, identify real obstacles in the environment, and come up with a plan for stretching dreams to the sky; not being internally focused and based on hitting fabricated targets, but throwing open the shutters and look outside. Such a budgeting system must be focused on two questions:^[11]

• How can we beat last year's performance?
• What is our competition doing, and how can we beat them?

Other alternative approaches include:

Rolling Forecasts / Rolling Budgets: A rolling budget is a budget or plan that is always available for a specific future period by adding a month, quarter, or year in the future as the month, quarter, or year just ended is dropped. Thus, a 12-month rolling budget for March 2008 to February 2009 period becomes a 12-month rolling budget for April 2008 to March 2009 period the next month, and so on. There is always a 12-month budget in place. Rolling budgets constantly force management to think concretely about the forthcoming 12 months, regardless of the month at hand.^[12]

Flexible Budgets: The concept of flexible budgets is an extension of the traditional budgeting methodology that is most valuable when the company expects or any experience wide variations in levels of activity within some area of the company, such as sales, or if many of the costs vary directly with those levels of activities, e.g. they are direct costs tied to sales, and the budget controls for these costs would be marginally useless if activity levels were significantly different from those in the budget. In such situations, direct costs are budgeted for various levels of activity and the budget used for comparison with actual results is the budget that is based on the actual activity levels achieved.^[13]

Beyond Budgeting: Beyond Budgeting, promoted by the international movement Beyond Budgeting Round Table, advocates the replacement of the traditional budgetary control system with an assortment of 'adaptive processes'. These are planning and decision-making processes that are not strictly part of the traditional budgetary control system. Such a new budget system would show summary figures of sales, costs, profits, and cash flow, which enables managers to review the financial outlook of the business without being constrained by the corporate financial year used for the annual reporting cycle. This removal of the traditional budget process must be accompanied by the removal of fixed performance contracts and therefore organizations are able to change the attitudes and behaviors of people at every level of the organization, incl. eradicating the undesirable behaviors that result from setting a fixed target that must be met even though the outcome is highly uncertain. To manage without annual budgets, organizations should adhere to the following six principles:^[14]

• Base goals on external benchmarks rather than on internally negotiated targets.
• Base evaluation on rewards on relative improvement contracts rather than on fixed performance contracts agreed upon in advance.
• Make action planning a continuous and inclusive process rather than an annual and restrictive exercise.
• Make resources available as required under KPI accountability rather than allocated in advance on the basis of annual budgets.
• Coordinate cross-company actions dynamically according to prevailing customer demand rather than a predetermined annual master budget.
• Base controls on effective governance and on a range of relative performance indicators rather than on fixed reviews against annual plans and budgets.

Better Budgeting: Better Budgeting, also known as advanced budgeting, intends to increase the efficiency of the traditional budgeting approach, mainly by streamlining budgetary processes through market orientation and optimization. Therewith better budgeting aims for a more flexible and less resource-consuming design of budgeting. The designing elements of a better budgeting approach are:^[15]

• coordination through budgets: adapt the coordination of traditional budgeting for increasing complexity and dynamics
• decentralization: increase the flexibility of the budgetary process by a decentralized authority
• focus and criticality: reduce the level of detailed budgets and thereby increase the speed of forecasting
• analytical planning from baseline: no longer based on the previous year's effective figures
• strategy orientation: establish a strong link to strategic planning
• rolling forecasts: follow the changing market conditions by not restricting the planning to the financial reporting requirements
• self-control: foster focus on materiality through self-control of the respective budget responsible
• reduction of dysfunctional effects: avoid dysfunctional effects, such as budget buffers, by not leading people based on budgets
• stronger support of the planning process with adequate tools: achieve cost effectiveness by using planning applications.

Besides tailored approaches, Damian Markus Slebioda names zero-based budgeting and activity-based budgeting to be two examples of better budgeting approaches.^[16]

Kaizen Budgeting: Budgeting approach that explicitly incorporates continuous improvements during the budget period into the resultant budget numbers.^[17]

Methodology

Conditional budgeting derives many ideas from multiple budgeting approaches, however, it is unique in the way how it combines budgeting and analysis of the current status, and then releases expenses (while other budgeting approaches compare variances between actual and budget). The budget becomes a process for everyone to agree on income probability and expense priority. It no longer defines a certain level of expenses; rather, it is a process for an organization to agree on what income and earning level to release what amount of expenses and resources.

The budgeting approaches that served as the foundation for conditional budgeting include traditional budgeting, zero-based budgeting, better budgeting, and beyond budgeting. While building on the strengths of these approaches, conditional budgeting avoids the disadvantages of these approaches for organizations or in times of unstable income streams. The two main benefits are:

1. Expenses are budgeted according to priority level and in correlation with income and cash flow. In the effective year, expenses are only released based on the corresponding positive income and cash situation.
2. During the effective year, the ongoing analysis does not explain deviations, the analysis rather focuses on defining the appropriate point in time when to release the conditionally pre-agreed expenses.

Planning objective

While any budget approach aims to think through different future scenarios and the respective reactions of the company regarding capacity and resources, different approaches set different priorities regarding other aspects, e.g. how flexibly resources shall be adapted to changing market conditions or who shall be entitled to define targets.

One of the strengths of traditional budgeting is its integration with financial reporting. While this close relationship is also mentioned as a disadvantage above, all organizations remain to be confronted with financial reporting (see also Financial statement).^[18] One advantage arising from this close relationship is that financial reporting, as well as traditional budgeting, have established procedures how operational figures regarding sales and costs (at all levels, departmental up to group-wide) are reflected in the Income Statement, and then combined with capital expenditure and financing roll into the Statement of Financial Position, Statement of changes in equity and cash flow statement. Given the growing importance of the Statement of Financial Positions (the financial situation of companies is no longer dependent on the Income Statement only, Financing and the Statement of Financial Positions enjoy increasing importance), allowing the budget to use existing and established mechanisms to roll into a full set of financial reports can clearly be used as an advantage. And so it is the reuse of existing knowledge regarding the interpretation and taking decisions based on financial reporting and Financial ratio (this aspect relates to the above-mentioned advantage of communication).

A third objective besides reusing the existing advantage of integrated financial analysis and building on existing financial reporting knowledge is the ongoing review of actual versus budget and taking corrective actions if necessary. While other budgeting approaches allow analyzing such variations after they did occur, conditional budgeting strives to take a more proactive approach. It only releases costs only after a pre-defined level of income, which has jointly been agreed upon to be necessary to release the costs, has been achieved.

Planning income

As suggested by Peter Drucker, income is key for any business: there are only cost centers within a business, and the only profit center is a customer whose check has not bounced.^[19] However, estimating income is not an easy task, and it might be harder for certain organizations such as NPOs (Non-profit organizations) being dependent on the number of visitors or NGOs (Non-governmental organization) being dependent on donations), or at certain times such as during changes in consumer habits (e.g. consumers avoiding department stores and turning to fast fashion retailers), society values (a company is perceived to be involved in a scandal, e.g. Shell's income in Germany fell by 50% during the Brent Spar crisis^[20]), or during economic crises.

Based on this understanding of fluctuating income, conditional budgeting requires executives to plan income at the following four stages:

• secured income: income that is very likely to be achieved, even under pessimistic scenarios. This income results from normal ongoing operations and includes a certain amount of fixed cost and/or sunk costs, i.e. expenses that apply regardless of the level of income resulting from the activities. Information for this stage may be drawn from existing orders (but only non-changeable, fixed orders) or from previous years coupled with market analysis for the budgeting year.
• additional income: this stage holds any additional income that is planned to be achieved through additional income-generating activities. Such activities might include special advertising campaigns, opening new locations, entering new markets, or running a new fundraising activity for NPOs. It is important to distinguish which of these activities are necessary to stay in business (i.e. to achieve the secured income in the long run) and which really lead to additional income for the budget period. Several similar activities may be bundled into one single activity for simplicity reasons. Besides planning income, the additional expenses for such activities including direct variable cost (see also indirect costs) must be budgeted as an income deduction.
• optimistic secured income: while secured income is planned pessimistically, this stage describes what income may realistically be expected from the ongoing activities (assuming that the results are realistic to somewhat optimistic). Any additional direct variable costs for this higher level of income must be deducted from the optimistic secured income. As all fixed and/or sunk costs are already accounted for at stage one, and therefore this higher level of optimistic secured income contributes directly to the gross margin.
• optimistic additional income: while additional income is planned pessimistically, this stage describes what additional income may realistically be expected from additional income-generating activities (assuming that the results are realistic to somewhat optimistic). Any additional direct variable costs for this higher level of income must be deducted from the optimistic additional income. As all fixed and/or sunk costs are already accounted for at stage two, and therefore this higher-level optimistic additional income contributes directly to the gross margin.

These four stages result in a minimum income, consisting of stage one and stage two, and a maximum income, consisting of all four stages. These two income levels, minimum and maximum, will then be compared to planned expenses.

Planning expenses

For planning expenses, the organization shall take a strict analysis regarding the necessity of expenses. Expenses then are grouped according to how important the payment of the respective expenses is regarding the success and survival of the organization. While in most cases the costs may be assessed regarding their importance to the success of the companies, in times of crisis an organization may be forced to rate the importance of their expenses according to the survival of the organization. The four groups of expenses are:

• fixed expenses: these expenses are absolutely necessary and may not be avoided by any means unless drastic consequences for the organization are acceptable. Which expenses an organization may recognize as fixed is largely dependent on its current situation and might be determined by contracts and law, especially labor law. These costs include the direct variable costs associated with the secured income.
• Priority 1 expenses: such expenses are of high priority, they may even be vital for the long-term survival of the organization, but not for the short-term survival. Priority 1 means that as income and cash get available during the budget period, these expenses are the first ones to spend the income and cash on. A later discussion has to define if these expenses shall be released all at once only or if the partial release may apply. Examples of these costs may include education and knowledge building for a services firm, product development or machinery optimization for a manufacturing firm, or additional projects to be financed for an NPO.
• Priority 2 expenses: such expenses are of lower priority, but still important for the organization. Examples may include research & development, acquisitions, or market expansion.
• Priority 3 expenses: this group holds all remaining expenses. These may be things like donations to charities, employee fringe benefits, bonuses, rebuilding, cafeteria discounts, or sponsoring (these examples may not apply to a specific organization where the respective activities are key for short-term survival or short-term success).

These four groups result in minimum expenses, consisting of fixed expenses, and maximum expenses, consisting of all four groups of expenses.

Planning cash

Based on the cash flow calculation according to the cash flow statement, changes in cash result mainly from:

• operating activities: net income before depreciation, changes in working capital, and changes in provisions
• investing activities: investments and disinvestments
• financing activities: transactions with owners as well as borrowing and repayment of loans or other forms of financing

Planning of cash focuses on investment and disinvestments as all other figures are derived from other planning sections (income, expenses, and financing). For simplicity reasons and as for a majority of companies' disinvestment many enjoy minor significance only (exceptions apply), disinvestments shall be planned at one stage only. For investments, the same stages apply to the planning of expenses. In total, the planning of cash consists of the following five stages:

• disinvestments: planning of cash and profit on disinvestment (sales price compared to book value)
• fixed investment: investments are absolutely critical for the success and survival of the organization.
• Priority 1 investments: investments that shall be released immediately after respective cash (and income to cover additional depreciation expenses) is available. Similar to the expenses, a decision has to be taken if priority 1 investments have to be released all at once or if they may re partly released as the cash and income situation allows to do so partly. If partial release applies, further decisions have to be taken on the sequence (having 120 cash available, shall the one big investment for 100 or the 2 small for 50 each be released?).
• Priority 2 investments: investments being less critical, but still important.
• Priority 3 investments: all remaining investments.

These five stages result in minimum cash, consisting of disinvestments and fixed investments, and maximum cash, consisting of all five stages.

Planning financing

Planning of financing requires planning all financial positions that influence the required level of financing, including accounts payable, accounts receivable, inventory, loan, provision (accounting), and equity (finance). As these positions influence one another (e.g. additional investments may be financed by different ratios of loans and equity), they must be planned dynamically. All these figures must be planned in two stages:

• Minimum: amount/value of each figure in case of minimum income, expenses, and cash.
• Maximum: amount/value of each figure in case of maximum income, expenses, and cash.

Providing additional ratios, e.g. inventory turnover, may help to define the right value for each figure.

The planning of financing at the minimum and maximum level provides the remaining figures to integrate the different planning and take the necessary budget decisions.

Tying the planning to a budget

After all necessary details have been provided to result in minimum and maximum income, expenses, cash, and financing, the plans can be tied together into an integrated budget. However, this first requires to:

• provide the Latest Estimates and therewith an actual forecast for the current year: as budgeting normally takes place in autumn (in case the financial year matches the fiscal year), figures that indicate the situation at the end of the current year must first be provided to then provide the correct calculation, especially for the Statement of Financial Positions. These Latest Estimates are critically important, for if they are wrong, the budget may not be suitable as a decision basis (e.g. if the amount of cash available turns out to be significantly below the forecast amount, Priority 1 investments may realistically never be likely to be released during the budget period).
• provide some additional ratios, including depreciation rates, interest rates, and tax rates. These ratios will be used to provide the respective automated calculations, e.g. to automatically calculate the depreciation expenses for the capital expenditures. These calculations are especially helpful to later suggest releasing priority 1, 2, or 3 expenses and capital expenditures, as they allow automatically calculating all consequences of any such decision.

The resulting budget shows the integrated minimum and maximum figures. At least, the minimum budget should be positive (i.e. the minimum income and cash cover the fixed expenses and capital expenditures). Ideally, the maximum budget is also positive, i.e. under realistic-optimistic assumptions the income pays all expenses and capital expenses. If the maximum budget seems adequate, inform the respective people that priority 3 resources may never be released through the budgeting period and therefore they may be taken off the plan. Alternatively, additional income-generating measures or fund-raising may be planned in order to ensure a positive enough income and cash situation to possibly also accommodate for Priority 3 expenses and capital expenditures. And these are the discussions on resource priority that a budget intends to foster to then agree on the focus of the respective period, and therewith having the possibility to set a different focus for the next period (e.g. invest in people the first year, and the following year invest in machinery).

Such iterations bear the risk that one additional income-generating measure is added after the other, which may reduce the overall effectiveness of each measure. Other potential violations of the budget structure include increasing the level of optimistic income. While such violations are real risks, it is a question of leadership to gear the discussions in the right direction. The conditional budgeting approach may provide supporting ratios for cross-checking and comparison (e.g. revenue by salesperson, if increasing too much optimistic income levels may be estimated too high).

Budget review: analyzing conditions

The first step of analyzing actual results with the budget is to enter effective figures for the previous year (the forecast at the time the budget was established). If the effective figures divide too far away from the forecast figure, the budget may be not achievable (e.g. the available cash is too low for fixed investments even). Then the current year figures are added, following the same structure as the budget (four stages for income, four stages for expenses, and five stages for cash).

Based on the actual situation of income and cash, the assessment of releasing priority 1, 2, or 3 expenses and investments may be discussed. Therefore the organization does not have to stick to one of the scenarios or alternatives that it decided upon some months ago, rather the organization understands what the current income and cash situation are, how much additional income may be expected, and what the impact of releasing the next bundle of expenses and investments is. Therewith, the discussion turns from analyzing variances and possibly explaining why the actual did not turn out to be what the budget was, the discussion is more forward-looking focusing on how much the income and cash have to increase before additional expenses are released, and how such an increase may be achieved.

While conditional budgeting may support an organization regarding if the income and cash conditions are meat so that releasing the next bundle of expenses and investments is safe, the organization still has to decide on the details of such a release:

• shall all expenses of one bundle be released at once (all expenses and all investments)? If so, what happens to 'remaining' income and cash at the end of the period, is it brought forward to the next period (so in the next period it is already available to release priority 1 expenses and investments)?
• may allow certain expenses and investments to be released independently (i.e. do different items in the priority 1 group have different priorities?)
• if certain expenses and investments are released independently, how do we decide upon which are to be released (if 120 income is available, should one big expense at 100 be released or two small ones at 50 each)? May such decisions be different at the beginning of the period than at the end?

While traditional budgets answer such questions upfront, organizations using conditional budgeting may be confronted with such questions several times during the budget period. Answering these questions may be difficult as the expenses in one bundle may be of very different character, e.g. Priority 2 expenses may include individual education for staff as well as upgrading the office software package to the current release. While upgrading the software requires all installations to be upgraded at once (otherwise the heterogeneous environment may cause even higher costs), selecting what employees to allow to attend an education needs to be aligned with leadership, motivation, and compensation approaches.

Examples

Conditional budgeting has been used successfully at Foundation Green Ethiopia, an NGO supporting agriculture and afforestation projects in rural Ethiopia. Any project expenses are clearly tied to respective income. Conditional budgeting has allowed the organization to successfully implement projects to benefit rural farmers in Ethiopia, and it has allowed the organization to smoothly grow 5-fold within 10 years without adding more complexity to the budgeting and financial performance measurement. Instead, the resources have been used for conducting projects, managing operational performance, and therewith focusing on income and growth instead of managing costs and expenses.

See also

• BBRT.org - Beyond Budgeting Round Table
• Budget
• Zero-based budgeting

References

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