Page 5: Setting and using budgets
Having established the core financial objectives, often referred to as key performance indicators, the strategies to achieve them can be set in one of two main ways. The budgeting process can be:
- 'top-down' - i.e. set by senior managers and directed downwards, often based on previous results
- ‘bottom-up’ - i.e. evolving upwards from middle managers, through the use of detailed analysis, for confirmation by senior management.
In practice, at Zurich there are elements of both approaches. Senior management undertakes the topdown 'ambition setting'. This gives the strategic context. Managers then consider historical data, prevailing trends and any new drivers in order to formulate proposed budgets.
Zurich Business Partners help to ensure 'joined-up budgeting' between areas of the business:
- Revenue centres generate income. They prepare sales budgets.
- Cost centres generate expenses. They prepare operating or production budgets.
- The profit budget draws together all the budgets for revenues and costs to meet overall financial objectives.
An alternative approach to incremental budgeting is zero-based budgeting. This means that each expenditure budget starts with a zero allocation each year. Managers must justify each element of the budget they propose. This has the advantage of making managers think proactively about what funds they need. It also avoids the tendency simply to add a percentage of the previous year’s budget or assume that expenditure will remain the same. However, one major disadvantage of this approach is the increased demand on staff time, which is an expensive resource with an opportunity cost.
Monitoring the budget
The first results against budget may show that the business is not exactly on target. The budget then becomes a ‘dashboard’ to assess all the factors and make the necessary changes to reach goals. Variance analysis is used to identify differences between budgeted and actual figures. This can be demonstrated using the illustrative expenditure budget for UK Life.
Results better than or on budget are 'green' and represent no immediate problem. They may be worth investigation to understand new practices or to exploit new opportunities. Results that are only mildly outside expectations are 'amber'. These may need attention particularly if there is a worsening trend. Finally, there are the adverse (‘red’) results. Red areas demand immediate investigation and remedial action to bring performance back to budget. All results should be investigated based on the level of risk each deviation poses to meeting the overall business goals, but priority should be given to red areas.
Zurich Business Partners assist managers in understanding and explaining current performance by identifying the root causes of any deviations from the budget. They also look forward – known as forecasting – to assess how those deviations will affect the performance compared to the budget over the remainder of the period and in the context of overall objectives.
A deviation may be explained by an unforeseen event; it may be the beginning of a major adverse trend that requires a counter-strategy. Analysing recent trends can act as an ‘early warning’ system and may indicate how the business’ performance will evolve in the future.