Making Money by Budgeting Your Business
A. E. NASH, C. A.
EDITOR’S NOTE:-^—Mr. Nash is a member of the Canadian firm of Chartered Accountants, Clarkson, Gordon and Dilworth, of Toronto and Montreal. He has come into particular prominence during the last few months owing to his work in connection with the Home Bank case.—J. V. M.
IF YOU were chief executive of a big manufacturing concern for a number of years at a salary of $30,000 a year, and you returned to your office on Monday morning to find that henceforth you would receive only $15,000 for the same job, what would you do?
This is a situation which, a short time ago, confronted the president of a business the name of which for obvious reasons it would not be politic to mention.
Shortly before it came about, the president, in response to a request, interviewed the manager of a bank which had been financing the concern. Things had not been going well with the company, and when his visitor was seated the banker came straight to the point.
“Before the war,” he said, “your company had a sales volume of $100,000 a month or $1,200,000 a year. The war created an unexpected demand for your product, with the result that your sales grew to $2,400,000. At the beginning of this increase your profits in ratio to turnover were increased, but expenses in all lines grew until soon the ratio was somewhat less than it had been before the increase. That is right, isn’t it?”
The manufacturer nodded and the banker went on:
“After the war the business dropped back to about $1,000,000 a year, and you found yourself saddled with enormous selling and administrative expenses, and losing money at a dangerous rate. In fact it has come to a point where, in the interest of this bank, we must have an investigation to find the exact cause of changed conditions and determine what can be done! We can’t advance you any more money. You owe us more than threequarters of a million dollars now.”
The manufacturer hesitated. He resented the fact that the bank could dictate the policy of his company, but affairs were desperate. Then, not altogether because he was forced to, but because he was that kind of man, he subordinated his personal prejudice to the good of the business, and gave his assent.
A firm of financial and industrial specialists was called in—surgeons of the business world. The cause of the trouble was not hard to find, but the remedy— that of reducing expenditures to meet sales—was found difficult to apply. Eventually a budget system was installed. The bank appointed a representative to keep tabs, said “go to it!” and sat back to watch.
Slowly the Corner Was Turned
THEY did “go to it,” and one of the first things done was to cut the president’s salary by fifty per cent. The next move was to dispense with the services of another highly paid official. That was a beginning; the application of the budget did noEstop there. Expenses applicable to every department were set out in minutest detail, commencing with the estimated sales for each monthly period of manufacture, and the system was extended to every ramification of the business.
Slowly but surely the corner was turned. The company was able to show a profit and the bank’s loans began to decrease. Present prospects are that within another few years the company with good judgment, will be able to substantially reduce its indebtedness to the bank, if not wipe it off entirely, and will be in a position to make satisfactory profits. This is altogether due to the institution of a proper and rigid budget, carefully prepared and conscientiously lived up to.
It would not be fair to say that all the big business failures and embarrassments in the financial and industrial world of the last few years could have been avoided if operating on a budget had been more in use, but in a great many cases businesses which have gone under would still be in existence, for the common good of owners and public, and in other instances losses would have been greatly reduced.
By budgeting, the losses sustained by so many institutions through deflation of large inventories, and the continuation of operations costing far in excess of the sales price of their products, could have been detected in time to prevent catastrophe, and constructive programmes
instituted which would have saved in the aggregate many millions of dollars.
A business may get into difficulty from a variety of causes, including general depression, excess competition, change in demand for goods, and other factors beyond the control of the management but, except in comparatively few instances wherein the business fails as a result of some unforeseen calamity, and excluding failures caused directly by the war, nearly every failure in business can be traced to inefficient or bad management. in some degree.
It is not necessary for a concern which has an economic right to exist to get into such a serious financial position that some substantial saving cannot be effected. A budget system would have the effect of showing the results of the business and financial position of the enterprise so clearly from time to time, that action could be taken in time to avoid serious results.
Budget Plan and Control
THE planning and control of a budget for a business concern by outside agencies who have been asked for assistance is often a delicate matter, and one in which considerable tact must be exercised. Officials of a company have to be educated to the value of the system in such a way that their susceptibilities will not be hurt, and so that, eventually, they will be its most enthusiastic supporters. Without full co-operation and a thorough knowledge of its principles by all department heads and others affected, and a determination by them that they will live up to its provisions, it cannot be successful.
Individual egotism is a powerful influence in business and does not always oper-
ate to the good of the concern. Men who have had supreme control for a number of years often believe that with their intimate knowledge of the details of their business they must be more efficient than any mechanical system of control. The value of a budget often includes opening the eyes of executives to a large number of details within the business, of which they were not aware.
For Budgeting Information Refer to:
“Budgetary Control for Businesses,” by J. O. McKinsey; “Controlling the Finances of a Business,” by J. O. McKinsey and Stuart P. Meach; “Controlling Cost to Make Packard Profits,” by Packard Motor Car Co., Detroit; “Budget System of the Guaranty Trust Company,” by Stuart H. Patterson; “System,” for January, 1923; “Factory,” for July, 1921, February and June, 1922, April,
1923; “Industry,” for June 17, 1922; “Administration,” January to August, inclusive, 1921,
October, 1922; “Paper Trade Journal,” for January 28, 1923; “100% Management,” for June, 1922.
In addition to the above, valuable information may be obtained by application to the following;
United States Chamber of Commerce, Washing D. C. ; National Society of Cost Accountants of New York; American Institute of Accountants.
“Special Libraries” for June,
1922, published a comprehensive list of references on business budgets.
Many businesses will find difficulty in planning and carrying out their operations on a uniform basis, due to problems peculiar to themselves. All well-managed concerns should determine a suitable future policy, deciding what the expenditure must be within a given period, and deciding on the most economical way of providing funds for them. This method is referred to as budgeting the business. This term has been widely used and frequently misunderstood, but contrary to the belief of many it is not a new idea. The sizeof the business and “seasonal requirements” will have considerable bearing on the length of that period, which will vary from a month to a year, and in a few cases even longer.
Some business men will say that they have tried the budget system without success. Analysis would likely show either that the plan was carelessly laid out without proper consideration of essential points or, more probably, that the plan was not carried out as intended; that expenses provided for in the budget were exceeded without proper cause, and the system was not made elastic enough to take care of fluctuations in sales, income or production. To be successful budgets must be planned so that they may be altered without delay to meet changing conditions, while one of the greatest essentials is that they must be strictly and
properly controlled—although not followed slavishly and without reasonable judgment.
Cases occur wherein the position of the company becomes so bad that nothing can be done to save it, and it is more economical to wind it up than to attempt reorganization even under a carefully planned budget system.
In “Corporation Procedure” published by the Ronald Press Company, Montreal, appears an interest ing example of how a budget might have prevented failure.
Lost—a Million and a Half
A PROSPEROUS business became embarrassed in the spring of 1913 and a few months later was reorganized. A loss of $1,407,000 during the year preceding reorganization was explained in part by lack of co-ordination between the sales and manufacturing departments. During the early months of the year, owing to the forcing of sales, the factory had to run day and night, involving high labor rates, the use of unskilled help and excessive cost at every point. During the latter part of the year the factory was shut down, the loss from manufacturing alone being approximately $1,100,000.
A fundamental mistake was made in the sales department in that there was complete misjudgment of the market for manufactured products, on the rate of gross (profit) which could be safely attained. The reduced volume of business should have shown a reduction in sales expenses of $600,000 to maintain the same ratio which held iri*1912, but there was an actual increase of $600,000, making a relative increase of $1,200,000. Interest charges were increased by more than $800,000 due to an excessive inventory and the high interest necessitated by the company’s condition.
The company’s embarrassment was directly due to the accumulation of a large inventory of raw materials, goods in process and finished products to the amount of $16,500,000. The expected increase in business failed to materialize and sales expense was increased greatly_ by an illadvised effort to dispose of this product. Care and foresight in drawing up a cash budget prior to the commencement of 1913 would have been sufficient to assure a reasonable degree of co-operation between the sales and manufacturing departments during the year. Such foresight would have prevented the extraordinary absorption of cash reserves in expenses and inventories, which inevitably culminated in receivership.
In the business of governments it is customary for executives to submit to the legislative power a detailed estimate of the prospective revenue and outgoings for the next fiscal year. This is a budget; it is a protection only, and not a record of results.
In municipal circles the principal item of importance near the end of any fiscal period is the preparation of the next budget, which becomes a starting point for municipal activities, including accounting. This is the financial programme and, as such, is the most important report of the municipality.
In manufacturing, commercial, and financial business administration many difficulties which arise are due to lack of forethought. Frequently no proper attempt is made to co-ordinate the various activities of the business in the light of past and present experience, with a view to planning and adopting the best course for the future. Almost the only justification for investment in a business is the expectation of its ability to earn profit, so all operations should be conducted with this end in view.
It is hardly necessary to emphasize the folly of administering a business as a number of more or less separate departments, any or all of which may be following individual policies without regard to the interests of the business as a whole. To obtain the highest degree of financial success there must be careful co-ordination of all departments through a central financial control.
Nearly all businesses practise some form of budgetary control in a greater or lesser degree. Business men frequently deny
that they operate a budget, yet investigation will show that they both prepare and make use of estimates.
Useful for Small Business
IT IS not only the big business which needs to apply the principles of budgeting. Frequently the need is greater in those smaller concerns, which cannot afford systems of cost accounting and other methods of keeping check which are part of larger concerns. In smaller businesses the system generally is easier of installation and operation, for the reins are in the hands of fewer men and analysis of the situation is simplified.
Occasionally one comes across cases of unconscious application of budgeting principles. Some time ago in a newlybuilt district near Danforth avenue, in Toronto, a grocer opened a small corner store. His capital was not large but he put in as extensive a stock as he could arrange for, and in the first few months did well. Many people were building homes in the vicinity and as he was first on the ground he got the business. He hired a clerk, and a driver and rig, and began to congratulate himself upon his quick success.
A check-up of his indifferently kept books, however, showed that his prosperity was on the surface. In addition, a period of depression came upon the district, and many people sold their homes or were foreclosed and moved away. The merchant made an analysis of his position. He discovered that certain lines of goods, such as expensive brands of tinned goods, no longer were selling. His overhead was too great and there were several small wastages which could be avoided.
Immediately he arranged with his jobber whereby the more expensive lines were returned and staples substituted. He let his driver go and used his clerk for delivery in the non-rush hours, hiring a boy with a bicycle foT after school and the evening rush, set himself a limit for the purchase of commodities with a restricted sale, adopted a definite cash limit of buying for general goods, based upon actual average sales over a period of weeks, and held rigidly to this program. A later checking up showed that, even with depression still in force, his business was paying where other merchants were being forced out. So he looked further.
His location was logically sound and in the path of city expansion, so he set aside a definite percentage of his net income for the specific purpose of enlarging his business when the right moment arrived—as arrive it did. He is now firmly established in a profitable and still growing business. This man was not conversant with the technicalities of big business and finance. He did not know how to term his procedure, yet he was operating on a budget just as surely as though he had studied its principles from the standpoint of a million-dollar business.
An Ugly Alternative
A LARGE retail business, whose sales had been falling off gradually for a considerable time, due largely to heavy competition, found itself losing money every month. The situation became such that experts were called in. The remedy they suggested was to cut expenditures to meet the reduced business. It was necessary to curtail spending in every line— even the salaries of the management being included in the drastic reduction— and a change in the location of the business was advised to obtain a much lower rental charge.
When the budget was first planned the management considered it would be impossible to carry it out, but when faced with the ugly alternative of closing down it was decided to make the effort. The result was that within three months of the institution of the budget the company was able to show a small profit without any increase in sales. This profit continued to grow and the probability is that it will continue.
In the installing and operating of a budget certain important points must be considered, among which are:
1. Length of the budget period. This will depend upon the nature of the business.
2. Responsibility for preparation of estimates. These should be prepared by the department heads responsible for their performance. Because of the interdependence of departments the general plan must include provision for mutual
inspection and use of each other’s estimates by all department heads.
3. Responsibility for the proper execution of the budget and reports of actual performance. A budget should be controlled and if estimates are found impracticable necessary changes must be made promptly.
4. Co-operation of all employees with the management. No plan can be successful if those responsible for its performance are not working together.
It is of utmost importance that factory cost of production be accurately determined. If there is any material error in making this estimate the final results may be serious, for on many occasions a business disaster has been caused by inaccurately estimating factory cost—which consists of material, including freight and duty, labor, and actual factory expenses. It is regrettable that so many large manufacturers have little and often inaccurate information on this matter.
Full co-operation between sales and production departments is essential. In order to estimate the sales for the proposed budget period it is necessary to prepare in all details the prime costs and overhead costs of the products to be sold, so that sales prices of the different products may be determined. In addition, sales and production budgets must be prepared both in terms of articles made, and dollars and cents.
In considering the relation between sales and production the following points are important:
1. Production must be sufficient to fill orders and maintain proper stocks, but not to create an overload of stocks.
2. Can the desired amount of goods be produced with the present equipment?
3. If additional equipment is required, can it be procured in time to produce the desired amount of goods?
4. Can additional equipment be financed and operated profitably?
This last point brings out the seeming paradox that an immense increase in business does not always mean prosperity for the concern it is intended to benefit, particularly if it comes in the form of unexpectedly large orders which are beyond the present capacity of the equipment. It should be the policy of every business to have constantly in mind the possibility of enlargement of plant, staff and equip-
ment, and a detailed plan of procedure and policy to be followed in emergency.
Value of Looking Ahead
SOME time ago a manufacturer in a small way of bridge and structural steel was offered a large contract. It was not a tremendous thing but he had to turn it down, because it was beyond his capacity to finance and he had neglected the vital business factor of financing ahead and making provision for such a contingency. It is likely that his greatest loss was not so much in the actual passing up of this job, but the loss of future business which this contract might have brought in its wake.
The item of returned goods and the almost inevitable loss that must follow is most vital in businesses whose product is either of a seasonal nature or what is know as style goods. The fault does not always lie with the manufacturer. There may be unexpected cancellations and returns of large shipments, or other reasons beyond his control, but in a great number of cases the return of goods can be traced directly back to factory defects or mismanagement. Sending out goods inferior to sample is one of the main and most inexcusable causes—that and neglecting to ship goods when and as promised. While returned goods usually can be re-sold, it is unlikely that the full sales price can be obtained, and many outside firms, including department stores, thereby make profits which would have gone on the books of the manufacturer had business sense been used. It is necessary, then, to make full provision for this item when preparing the budget.
The ratio of overhead expenses to sales decreases as the sales increase, provided other factors are constant. A working average of operation is sixty-five per cent, production costs to thirty-five per cent, overhead costs. Let us suppose that the sales price of a certain article is one dollar; that of this total the cost of material and labor is sixty-five cents; the factory burden is fifteen cents; and the selling and administrative expense fifteen cents—a total of ninety-five cents; this leaves a profit per article of five cents. Assuming the budget is planned for the production and sales of one million articles at one dollar each, the profit would be $50,000. If sales
increased to $1,200,000 there would be a corresponding increase in cost of labor and materials, and also in the factory burden and administrative expense but, in the case of the last two, not to the extent of fifteen cents per article. So the saving in these two items of cost would yield substantial additional profit.
Under certain circumstances it may be advisable to budget either on a maximum or a minimum plan. Under the minimum plan the budget must be elastic enough to take care of sudden expansion; in the maximum plan, while greater profits may be possible greater risks are involved.
Gross profit must not be the only point considered. There have been many cases where consideration has been given only to the amount of business which can be turned out to show a profit over the prime costs of production and factory overhead, and little or no attention paid to the heavy items of selling or administrative expenses. What must be considered is the final net profit after all expenses have been taken off. It will easily be seen that in some cases it will pay better to produce a small quantity of goods at a big profit than to produce and sell a large quantity at a smaller profit and, consequently, greater risk.
Two courses are open in the event that estimated expenditures exceed estimated receipts. They are:
■ (1) Reduce expenditures, which will entail careful revision of all estimates.
(2) Increase revenue. Operations may be speeded up without increasing expense, or the sales budget may be revised, but this must be very carefully thought out or „else expenses will grow.
Another course suggested by some is to obtain additional capital. This would be dangerous and could not be pursued for long. There may be occasions, however, when it would be justified.
Borrowing is Last Resort
A CASE occurred some time ago wherein an established business got into difficulties. Every possible source of revenue and saving within the concern was exhausted to a degree which in itself approached the danger point, but income could not be made to approximate necessary expenditure. The issue became so acute that money had to be obtained or the company would go into liquidation. The business was peculiar to its kind in that months of work, expense, and planning had to be given before even a small profit would show. Once it was established, however, there was every probability that it would continue in legitimate expansion, and a careful survey of the market was most promising. The chance was taken and outside capital obtained, and in this instance justified the chance—but it would not have been justified had not evidence existed that there was a market which, eventually would bring in adequate returns.
As another instance, a Canadian manufacturing concern making small novelties put in machinery for the manufacture of a certain article upon which it was felt certain sales results could be depended. At the time the management was doubtful whether too much equipment had not been installed. In the first week a salesman sold 600,000 of these articles to one Detroit department store—far more than the total equipment could handle or the firm finance. Machinery for the purpose was easy to get and instal and the market was sure, so this firm was justified in asking the assistance of a bank, and did, with gratifying results.
It is easier to lay out a budget than to control it. As control of expenses is one of the principal advantages of budgeting, however, it must be carefully planned. Proper classification of accounts must be maintained and various expenses correctly allocated so that those responsible may be able to check expenditures. This necessitates a prompt and regular system of reports showing expenditures and a close follow-up of those reports for explanation of excesses. Reports a month old are practically useless; the time that has elapsed between expenditure and checking is too long. Reports on all principal items should be made at least once a week with monthly reports in detail, and then the check should be quick and thorough. Beware of being lulled into a false feeling of security because the budget is installed. It will not work by itself. It requires watching and it is worth watching.