If the last few weeks were about financial performance at a corporate level, the upcoming lessons in this module are all about financial planning at a level we are involved in, the annual budgeting process for the groups that we're responsible for. Let's see what this is all about. If you are a Technical Manager or aspire to become a leader in your organization, one thing you will definitely be tasked to do is provide a budget to your boss about the program you oversee, or perhaps even the division you manage, or even the products you are responsible for. Your management colleagues across the company are doing the same thing, and all the budgets roll up to the Executive Office for review then usually backed down again with several required revisions. Every year, if not more often, companies prepare their annual budget forecasts for the next year. These forecasts include budgets for profit centers that are responsible for product sales. Here the product manager prepares a complete profit and loss statement for product sales, costs and profitability. Cost centers need to do this as well, including costs associated with the engineering departments, and research, and development organizations. Cost centers are essentially service groups to the rest of the company, and as such, don't generate profit the way a profit center would. Yet they too need to prepare and stick to their budgets, as a way for the company to control all those indirect overhead costs. Why is all this necessary? It's about the planning process, starting with the Executive Office, establishing the company's financial goals for the year. The Executive Office knows what's necessary to keep the shareholders happy, and therefore it sets targets for revenues, which it only has some control over, and for product costs, which it has much more control over. It also establishes the overhead costs for the rest of the organization, which is important if the company is to hit it's earning projections that we talked about, in the last few lessons. Once those goals are established, they are translated into plans, which themselves are translated into actions. Actions such as: Launching new products, creating new marketing campaigns, or perhaps constructing a new high-tech manufacturing center. The budget objectives and action plans are then rolled out to the rest of the organization, where each department creates its own action plans that are aligned with the corporate direction. Throughout the year, the company's actual financial figures are compared against the plan and if the two are not in sync, certain remedies are taken, such as budget cuts, if costs are higher than the plan or increased marketing if product sales are not meeting expectations. The point is, the Executive Office is responsible to the shareholders, and therefore sets the overall financial goals for the company. It's responsible for meeting those goals throughout the year. As the results are published every three months during the company's quarterly earnings report, and no one wants to miss expectations there. How are budgets developed? There are two basic approaches; the top-down approach and the zero-based bottoms-up approach. We've been talking about the top-down approach, whereby the C-suite effectively tells everyone what the corporate plan is. Those financial budgets and forecasts then cascade down to everyone else. Managers then look at their prescribed budget to see if there's any sense of reality to it. The other approach starts with each department, where managers start with a budget of zero, and then build the budget they need, of course, being able to justify every dollar they need. The department's budget might roll up to the division's budget, and the division's budget might roll up to the annual corporate financial plan. The reality is, there is always some combination of both top-down and bottoms-up approaches. The process is very iterative, as we'll see, until everyone can live with the result. The CEO is happy with the plan, the accountant can live with it, the engineering managers are all in good shape, and the field engineers are happy with what they get to work with. Once everyone is okay with the budget plan, it's all a matter of meeting the plan throughout the year. Let's see how the annual budget is typically developed. The plan consists of forecasts of revenues and costs on the product side, then an estimate of all the overhead costs. In my experience, here is how the revenue forecasts might get built for a relatively large organization. First, the Executive Office, the C-Suite, asks the Vice President of Sales and Marketing for their sales volume and pricing projections, as those two things are the company's revenues. The VP of Sales and Marketing, then ask their Sales Department for the sales volume forecasts, and Marketing Department for pricing on all the company's products. That rolls up back to the chief financial officer, who consolidates the sales volumes and pricing plans to get the company's revenue forecast. At the same time, the Executive Office asks the Vice President of Operations for the estimated product cost and overall cost of goods sold, based on those sales forecasts. The Vice President of Operations then asks their production departments for production costs, based on the sales volume forecasts. The Chief Financial Officer then consolidates the product cost data to get a comprehensive cost of goods sold forecast. Finally, the C-Suite determines whether the revenues and gross margins are sufficient to keep the investors happy. Then the C-Suite turns its attention to all the indirect costs, the company's overhead costs that go into the operating expenses. The Executive Office asks the Vice Presidents of all the cost centers for their annual cost estimates. Those Vice Presidents then ask their department heads for their annual budget plans and ultimately, these get rolled back up to the Executive Office, whereby the C-Suite determines whether the operating expenses are in line with revenue projections. The C-Suite prepares its proforma income statement, its forecast P&L, to see how it all comes together. Then the fun begins. The C-Suite tells the Vice President of Sales and Marketing, their forecasts for revenues are too low. Then they tell the Vice President of Operations, their production costs are too high, and they tell the Vice Presidents of all the cost centers, their costs are exorbitant and unsustainable. So everyone modifies their budgets, which roll back up to the Executive Office for another round of reviews. The cycle repeats itself a few times until everyone is happy or can at least live with the result. That's how things get done, a lot of back-and-forth until the plan aligns with the financial goals for the year. To sum things up, the plan is made up of estimates of sales and costs coming from the product profit centers, and all the costs associated with the service groups, those that support the rest of the business. As you'll be the one to prepare these budgets, let's see how this is done in more detail, starting with budgeting for profit centers, which we'll cover in our next lesson. I'll see you next time.
