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Thanks very much Robert. I wanted to present a very brief case study which is derived from our
company experiences in helping clients to deploy techniques to make forecasting and budget
review a more effective process within their organisation.
Budgeting is really part of at least two main processes within an organisation. The first (the loop
on the left), is looking at the internal control of the organisation. This is a feedback loop which is
saying that results happen, they get measured, they get analysed and then hopefully there's a
dialogue which ensues between the analysts and the line managers who are responsible for
performance. The result of this dialogue should be commitment to take effective action,
hopefully improving results in the future. So that's the internal use of management information
within an organisation. Budgeting is going to be a fundamental part of that because it sets the
basis for control and enables management by exception. Another aspect is when you start to look
outside the organisation at the information that an organisation publishes externally, perhaps for
compliance with the Companies Act and other regulations (the loop on the right). The
publication of those results will generate a response from the market. That response would
generally lead an organisation to set new targets for performance which would then be translated
into a budget within that organisation. There's the internal control aspect and also the external
aspect which feeds into the budgeting process.

Why do we bother to produce budgets at all? Well there's the argument that says that it forces
managers each year to step back from the day-to-day management of their operations and to
think a little bit more strategically, to think longer-term and to plan. Budgeting can also reveal
new data about the future. This may arise from looking at external data as part of putting together
sales budgets and forecasts; it may also arise from enhanced communication and co-ordination
within the organisation which the budgeting process can help to effect. It really requires
members in different parts of the organisation to co-ordinate their activities and to talk to each
other. Budgeting is also designed to give managers an indication of the actions they're supposed
to be taking and to motivate them to make those actions. It should act as a basis for controlling
activities, for example, by only looking at the significant variations of actual performance against
budget. Perhaps the most important aspect about budgeting is it facilitates the evaluation of
performance both of operating units and of the people within the organisation. Some of those
aspects can lead to problems in budgeting. Finally, the idea of goal congruence comes through in
budgeting. That is the idea that the actions of individual managers in charge of particular
divisions or operating units, should produce results which are congruent with the objectives of
the organisation as a whole. This obviously is a big issue in multi-divisional companies where it
can actually be quite difficult to provide incentives for managers always to produce and act in the
interests of the organisation as a whole, and not just to further their own self-interests.
Let us now look at some of the conflicting roles of budgets. There's a conflict between the use of
a budget as a plan and the use of a budget as a motivating tool. There have been various studies
of the level at which you need to set budgets in order to motivate people and what's generally
been found is that budgets which are slightly more than attainable are the best motivators. There
is a need to set budgets beyond just average performance in order to motivate performance. That
may conflict with the role of budgets as plans, of what actually is going to be achieved and there
may be a need to set two budgets, one which is a plan which is set at a slightly lower level than
the actual budget.

There's also the issue of political behaviour in budgeting. There are two main sorts of political
behaviour. One is soft budgeting, where managers in the operating companies try to get away
with relatively easy budgets in order to ensure that their performance-related bonuses are
achieved. There's the other sort of political behaviour which arises when their bosses impose
unattainable targets on them such that there is a lack of participation in the budget process.

The stages in a budgeting process normally start with a communication from the centre as to
what the budget policy is for the year with guidelines and briefing notes. You then identify the
limiting factor that will restrict performance, and in most companies that is the level of demand.
So the first element that you tend to prepare in a budget is the sales budget, because that is
obviously what is affected by the limit of demand in the market. Often the budgets are prepared
from the bottom up and unless you're adopting a zero based budget approach, which in our
experience is very unusual indeed, you start by looking at current performance, wringing the
latest forecast of the current financial year as the basis for your budget. When you review the
draft budgets for next year you compare them against the latest forecasts of the current year
position. There should then be a process of negotiation between managers and their superiors and
that process is very important. It has also been found that the most effective budgets are those
where budgets are not imposed, but which are the result of a participative process. There's the
process of overall co-ordination and review and then the final acceptance of the budget. Most
organisations have a budget committee which is responsible for approving the final consolidated
budget.

What I am going to talk about specifically in this case study are those tools that can assist you in
the budget review process. These are analysis tools primarily and the focus of the case study is
really in three parts. Firstly, if you're going to base next year's budget on a forecast of the current
year end outturn and use that as the basis of your budget - rather than going back to zero base
and saying what do we need for next year, regardless of where we've come from - you're going to
need to ensure that the forecasts that are coming through from the operating divisions are
actually a fair reflection of the current year outturn. You're going to be doing your budgeting
exercise perhaps four or five months before the end of the current financial year so you need to
be sure, or have some reassurance, that the latest forecasts you're getting from the operating
companies are a fair reflection of what is likely to happen during this current year. So, you want
to look at some techniques for divisional and group executives to analyse those forecasts. When
initial draft budgets are prepared, these are firstly looked at as annual budget figures before they
are broken down or phased by period. The third stage would be to validate the actual phasing of
those budgets. Is that phasing fair, is it unduly loaded towards the front end of the year or the
back end of the year?
My first chart relating to this case study is a process of evaluating the current forecasts for the
year-end outturn which are being produced by operating companies. This case study is based
around a consumer electronics company which operates in many countries around the world and
it sells four product lines: Video Cassette Recorders, TVs, Camcorders and Compact Audio.
We're looking here at the forecast for the United Kingdom region across all product lines. The
chart is looking at net sales value month by month for the current financial year compared with
the budget for this year. We're currently in September, so we've actual results for 9 months of the
year, compared against a phased budget for the full year. The computer has produced its own
forecast of the likely performance for the rest of the year and it has done that simply by fitting a
trend line through the historic performance and then weighting that for seasonality. The
cumulative variance month by month of the actual performance against the budget is plotted, so
by the time we get to September we can see that the organisation is slightly below budget, but
not by very much. The implication of the computer forecast is that the adverse trend against
budget may continue slightly. The computer is saying we're probably likely to end the year about
half a million pounds below budget. The contrast here is between that computer generated
forecast and the forecast produced by UK. What they are suggesting is that the year end position
is going to be much worse than that and they reckon that they're going to end the year about £1.4
million below budget. Our first step would be to investigate this forecast in more detail and see
where this adverse variance going to arise at the end of the year.
We saw the management forecast on the previous chart was indicating that they were going to
end the year about £1.4 million below budget. In this chart we're breaking down that variance by
product line. We can see that the main offender here is Video Recorders, which is forecast to be
about £0.9 million below budget at the year end.

What's the implication in terms of the year to date position against budget? Firstly, where are we
currently against budget by product? Well across all products we were about £130,000 below
budget for the 9 months to September. Again, we've got some work to investigate what is going
on for Televisions. For example, currently, we're above budget year to date for Televisions but
the forecast is saying we're going to be £700,000 below budget for the remainder of the year.

The computer here is producing a range of forecasts which we can use to compare against the
forecasts that the management in each of these product areas is producing. Each of the
management forecasts is shown by the brown lines, and the blue shaded bands here are a region
of four forecasts which the computer produces. Many different forecasting techniques can be
used but we advocate using very simple techniques. For example, we may forecast the remainder
of the year assuming it will be the same as budget or it will be the same as last year. Another
forecasting rule might say that if we are 10% up on budget say, year to date, let's assume we'll
end the year 10% up on budget. In Video Recorders the management forecast falls outside of our
computer generated forecast and it is lower than the lowest of our computer generated forecasts.
We seem to have an indication here that the management of that particular product line are being
unduly pessimistic, unless they happen to know something about the future which isn't implied
by the historic data were basing these forecasts on.

This chart is taking exactly the same data as the previous one but looking at the uncertainty
associated with each of those management forecasts. What is being plotted here is the variance of
each of the computer generated forecasts from the management forecast. For Camcorders, we're
saying the range of possible outturns is very wide, it's wider than for any of the other product
lines, but those computer forecasts are centred around the management forecasts. Therefore,
management seem to be forecasting around about the right ball park. On the other hand, the
computer thinks there's less uncertainty about the outturn for Video Recorders, but the
management forecast falls well outside of that band.
Let's take a more detailed look at the sales forecasts for the Video Recorders line. Here I have a
chart which looks very much like the first chart I started with. This time I've just overlaid last
year's monthly data so we can take a look at this computer generated forecast. Why are we
forecasting here that we're going to reverse this current upward trend in performance against
budget and end the year below budget? Well, it seems that this also happened last year, and it
probably happens every year. However, we still find the computer is more optimistic than the
management.

Now if we then step back and look at the same data over a longer time horizon, what's the
underlying trend in this business of Video Recorders? Is it in a growth phase of the product
lifecycle, a maturity or a decline? Well it seems probably to be moving towards maturity. There's
been a bit of a tail-off in the smooth trend, the moving annual average in this case at the
beginning of the year. But that tail-off has been reversed somewhat during the year, which makes
this computer forecast probably reasonable if not a little pessimistic.

Looking now at the impact of that forecast sales variance for Video Recorders; What's the impact
of that sales forecast on gross profit? We're now disaggregating the forecasts by the principal
lines of the profit and loss account, and what the chart is telling us is that although our forecast
for sales is quite pessimistic, our forecast for gross profit at the year end is less pessimistic. This
is because we're also reckoning that we're going to improve our gross margin in the remaining
three months of the year and that will be higher than budget by just over 1 percentage point.

Now if we look at that gross profit forecast in more depth, what might be interesting to do here is
to track the changes in management's forecast, or the revisions of the management forecast over
time through the year and compare that with the build-up of that profit over time in the
cumulative numbers. The History of the Year-End Forecast line here is plotting the revisions to
the management forecast over time. This particular company does a forecast in March, in June
and in September. We can see that the first time they actually revised that forecast was this
month and the first forecast looked terribly pessimistic compared with the budget and what
actually happened. By the time they got to September here they'd almost reached the forecast that
they'd made back in June for the full year. This indicates that these particular people appear to be
very poor at forecasting and the computer generated forecast here, although less than budget, is
still higher than the current management forecast that's being used.

The point is brought out even further in this next chart, which some of you may recognise as our
favourite "windsock" chart, which has probably saved our clients more money than any other
chart that we use. Here, were looking at exactly the same data as in the previous chart but in just
a different way. Here are our management forecasts with what seems like quite a steep revision
upwards in September. Those forecasts are compared with the budget for the year as a whole.
Again, we're using four different forecasting techniques each month, the simple forecasting
techniques that I alluded to earlier to produce a likely range of forecasts for the year end outturn.
When you look at this chart you need to recognise that each point is a forecast of the year end
position. For example, in January the range of forecasts that the computer produced was actually
very wide. It was saying you could end the year perhaps at £2.4 million or perhaps as high as
£2.85, something like that. You'd still be below budget though, and at no point in the year has
our range of forecasts included the budget line. It really seems like we are going to end the year
below budget. But there's been an improvement in performance through the year, so by the time
we get to September it looks like we're perhaps not going to be that far away from budget any
more. What's interesting is that the management forecast for Video Recorders falls outside of
that range, so again it's a prompt to ask the management of that product line what do they
anticipate about that future three months which the computer could have no knowledge of.
Finally, a similar chart which is examining the same range of forecasts produced on the
windsock chart and looking at the risk or the variability associated with each of the period
forecasts for the remainder of the year. Again, four different forecasts are compared with budget.
You can see that one of these forecasts is that performance will be the same as budgeted. The
range of those forecasts increases as you go through the year, so there's more uncertainty about
December than any other month. That range is actually quite large, as low as about £200,000 as
high as about £270,000.

There we have seen a range of graphical analyses that you could use to assess the forecasts that
are coming through from the operating companies, those forecasts upon which you're going to be
basing next year's budget. Let's now look at some of the techniques you can use to evaluate the
budgets.
Let's start with the year's total budgets, first of all looking back at sales for the United Kingdom.
The chart is breaking down all products by the four product lines and simply showing the current
forecasts for this financial year (those forecasts we've just been evaluating), and comparing these
with next year's budget. Well, Compact Audio is going to have no change on current year but the
other three product lines are all forecasting some increase on their current year forecast for next
year. We can magnify these variances here to see in a little more detail what's going on.
On this particular chart, Camcorders are showing a growth of about £1.3 million in next years
budget compared with the current year likely outturn.
If we then look at this same chart on a percentage change basis, that for the Camcorders product
line represents an increase of about 50%. All the other products here are showing an increase of
sales next year of less than 20% against the current year outturn.

A different way of representing that same data and also bringing in the impact on the rest of the
profit and loss account, is to lay out that data in what we call a 'radar' chart. The top row of this
radar chart corresponds exactly with the data on the previous chart. What we're plotting here is
the percentage change of next year's draft budget against the current forecast for this year. As I
mentioned previously, Camcorders were forecasting an increase of about 50% in sales value. For
the other product lines the forecast is less than 20%, and you can then see the impact on the other
lines of the profit and loss account here. Its going to have quite a favourable impact on gross
profit in the Camcorders line for example. This is a useful way of summarising data and
pinpointing where to investigate further.
Let us now take a look at the people involved in the budget process and the people who are
responsible for the Video Recorder line in the UK. What sort of people are they? Are they
optimists or pessimists? We can take a view on that by simply looking at the budgets that they've
set historically each year and then seeing what they actually produce. Are they consistently
above budget or below budget or a mixture of the two? Now, these people seem to be optimists
in general because each year they've failed to produce their budget, in some cases quite
significantly, and it looks as if this year they're going to do exactly the same thing. This is quite
interesting because we'd also noticed previously that they seemed to be trying to get away with a
soft budget this year by sandbagging - setting a lower forecast then they're actually going to
achieve for the current year. Maybe they've had a change of thought, maybe they're going to try a
different tack this year, or maybe the people have changed, I don't know. But it's quite interesting
to look over a longer-term time horizon to see what your people are like. I'm sure you know
anyway in many cases.

Finally, in this section, a few more interesting or unusual chart formats that we could consider
using for your budget review.
This sort of chart format we call 'business impact' charts. I tend to think of these lines as strategic
vectors because they have magnitude and a direction. What we're plotting here is the gross profit
margin on the vertical axis against sales value on the horizontal axis. If you multiply gross profit
margin by sales value you get gross profit and what the contours here represent are lines which
are of equal gross profit. If you took say 50% gross profit margin on £10 million sales you
should end up with £5 million gross profit. Now for each of the arrows, the starting point of the
arrow is the forecast for the current financial year and the end point of the arrow is next year's
draft budget. So we're looking at the magnitude and direction applied by next years draft budget
on where we currently are.

Taking Televisions, this is a fairly low margin product compared with our others. We're
forecasting quite considerable sales growth next year which is taking our gross profit up from
this range of about £4 million to the £5 million mark. On the other hand, the Compact Audio
product is high margin but we're forecasting our sales are going to remain constant next year, so
there is little impact really on the Gross Profit there. This is a format you can use to interrelate a
whole set of different indicators. You could try doing it for non-financial indicators as well, for
example the impact of product quality on sales volume, or customer satisfaction.
What I've tried to do here is just an attempt at the Boston Grid or my version of the Boston Grid.
In this case, I'm plotting total market volume on the vertical axis and market share on the
horizontal axis. Taking Video Recorders as an example, we're budgeting for our market share to
increase quite considerably next year at a time when the total market volume in that product line
is going to increase. On the other hand with Compact Audio, we're forecasting a decrease in our
market share in a contracting market. In this variation of the Boston Grid, you get the idea that
Televisions will be question marks, Video Recorders and Camcorders are stars and Compact
Audio is probably a dog.
We could look also at some charts to help us evaluate the phasing of our budgets, once we've
agreed the total figures for the year. In this chart next year's budget is compared with the actuals
for the current year and also with the actuals for the previous year. Here we've turned the
variance line around, so that it shows the cumulative variance of next year's budget on the
current year's actual or forecast, and that helps us to look at the phasing of the budget. What
seems to be happening is that we're loading next year's budget more towards the front-end of the
year, the first four months, so that the variance of next year's budget against this year's actual
builds up in the first four months and then remains fairly constant. It would be much more
worrying if we saw the variance line suddenly shooting up right at the end of the year. We'd be
saying we're going to improve on this year's situation but only in the last three months, which
means that if we miss that opportunity at the tail-end of the year, we're going to come in nowhere
near our budget.
We could look at the phased budget data over a longer time span and we could compare it with a
computer generated forecast. This probably gives away how we've arrived at some of the draft
budget figures. We've made a forecast and then we've upped it a bit. That may actually fit in well
with the idea of setting budgets at a slightly higher level than is achievable which I was talking
about earlier.
We could also look at smoothed data, Moving Annual Totals. This technique is particularly
useful when you're looking at budgeting because what tends to happen when you get a very
strange budget is a big discontinuity in this Moving Annual Total line. There'll be a big break at
a point in time and that sort of discontinuity is quite alarming because most companies do have
momentum like that of a supertanker, and it almost implies that the supertanker is going into
reverse if there is a big discontinuity in that sort of line.

Finally, a look at gross profit margins on a similar basis. Here the difference between the
computer generated forecast and the draft budget is quite similar.

I've looked very much in this presentation at financial indicators such as sales and profit margins.
There's obviously also a need to set budgets and targets for non-financial measures if you're
looking at the balanced scorecard and those are probably equally important as setting the budgets
for the financials. In many ways, they are more important because perhaps you should be starting
with the non-financials as the drivers of the financials. Budgeting also leads into the issue of
incentive schemes for managers, which is one of the points I mentioned right at the beginning.
The balanced scorecard implies that management should be rewarded not just on the basis of
financial results. For example, BAA reward their senior managers on the basis of a profit target
and on performance of five non-financial indicators. If you miss your target for one of your non-
financial indicators you lose 20% of your bonus, and if you miss two you lose another 20%, so if
you don't make any of your non-financial targets but you do achieve your profit target you get no
bonus.

In conclusion, I hope I've been able to show you some benefits from this approach to analysing
forecasts and budgets that will help to produce tougher, more realistic forecasts. There is a need
for better dialogue between operating company managers, divisional and group head office
managers in this approach, so we can conduct a more rigorous analysis of revenue and cost
targets, reduce our vulnerability to political budgets, make a more honest assessment of
performance related bonuses and use tools and techniques such as these to facilitate
communication and participation in the budget setting and budget review process.

p
 


Andrew, thank you very much. I wouldn't like you to think that my good friend Andrew Mosely
has a conspiracy theory approach to subsidiary and head office interactions, this is in fact the
case, but I wouldn't like you to think it! It is a classic example of the I'm from head office I'm
here to help you brigade, is that right? But joking apart, the problem I think on setting targets,
financial, non-financial, whatever; there is always some kind of political behavioural undertone
to this sort of process. He hasn't told that he had a side bet with his colleagues, they said I bet
you can't talk about doing financial budgeting for 35 minutes without a schedule in sight and he's
won, we haven't seen a single financial schedule. What he didn't tell us though, was that he was
going to show all these pictures with the different colours and we forgot to do the statistical
assessment of who in the room is colour blind. I've been able to do this while you've been
watching his presentation and I know that 2.2 men don't know the difference between the pink
line, the green line and the red line, but the good news is that only 0.13 of the women in the room
feel the same way because as you know there's a disparity between the incidents of colour
blindness. So thank you very much for that.

Can we just get a feeling from the room about how rigorously different you go into this budget
review process. To what extent is it a sort of rubber stamp of the main subsidiaries, to what
extent is it tearing apart, do you work with the subsidiaries to produce their budgets or are you
the audience to whom they have to be presented?

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One thing that Andrew also suggested to us in the background is that the budget review process
is often dominated by the financial groups, seen as a financial exercise even if it shouldn't be in
some way. Financial people are used to lots and lots of schedules, the people running the
business, if they're not financial are less used to those schedules. What are peoples experience
about using visuals, graphics and so on to communicate fundamentals in the budget review
process as opposed to back to the simple financial schedule?

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