• Department heads will then revisit their plans and revise them if
necessary.
• Department heads then make their budget presentation to the
CEO/CFO for their review of final plan. To the extent necessary, it is at this point that the department head may negotiate resolutions to any significant variances with the CEO to ensure overall strategic goals of the firm are met.
• Once finalized with the CEO’s approval, the CFO and CEO should
present the budget to the board of directors for final approval. Final numbers then should be distributed to each responsible line manager to ensure that they are fully aware of the final numbers to which they will be held accountable. In an ideal world, all of the steps described would be completed before the commencement of the new fiscal year. However, in practice it is not unusual for final approval to slip into the first quarter of the new fiscal year. In those situations, it is important to ensure that line managers know how to operate while waiting for the
budget to be approved, particularly the procedures required to procure
“emergency” items.
MONTHLY FORECASTING—UPDATING THE ANNUAL BUDGET.
Period-
ically, the annual budget should be updated to ref lect changes in the firm’s revenues and expenses that occur over time—both the actuals that have been booked year to date and the outlook for the remaining months of the year. Whether this occurs each month or each quarter is somewhat dependent on the volatility of the business, its capital reserves, and management’s preference. Updating the budget /forecast monthly, although arguably more labor intensive, provides management with an economic outlook for the firm based on the most current information available. Further, by incorporating the forecasting process into the monthly managerial routine, it becomes more efficient and less of a “big project” that tends to paralyze finance and management staff when it is left to a quarterly update. For the remainder of this section, we presume that the outlook for the firm is prepared on a monthly basis and is referred to as the “forecast.”
Development of the monthly forecast is much more of a bottoms-up ex-
ercise than is preparation of the annual budget because targets for the year already have been established and the validity of the forecast is highly dependent on line management’s current assessment of their capacity to achieve their targets given actual performance year to date. When preparing the monthly forecast, consider the following:
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• Set up a spreadsheet in a financial statement format that shows all major accounts listed in the same order shown in the firm’s financial statements going down the page, with a separate column for each
month going across the page. Array “actuals” for each month in the appropriate columns and budget (the first time the forecast is prepared) or the latest forecast for each line in the remaining months of the year.
Adjustments then will be made to each of the future months based on
the latest outlook for each account.
• Revenue forecasts must be made by client and must ref lect input from each responsible client manager. When the compensation agreement
with a particular client is complex, a supporting spreadsheet should be prepared and reviewed with the client manager. In some cases, particularly those where client managers are loathe to take responsibility for the forecast, it may be worthwhile for a senior financial person to sit down with the manager, review the calculations and, in particular, the underlying assumptions, and have the manager physically sign off that the projections are his or her best estimate based on knowledge at that point in time. Physical signatures, when managed properly, can dramatically improve the accuracy of the firm’s forecast.
• Expenses can be forecasted based on direct input from line managers as well as a top-down analysis of the historical run rates for routine expenses (e.g., electricity costs vary from $10,000 to $20,000 per month, depending on the month—simply estimate future months based on historical expenses by month, with a subjective adjustment to ref lect any percentage increase in rates or expected usage). In addition to a high-level review by account, financial managers may find it valuable to review the spreadsheet of expenses by vendor for each account to adjust for one-time anomalies past and future.
• Balance sheet and cash f low forecasts can be developed based on certain high-level assumptions. Most line items can be computed as a function of revenues or expenses, and the resulting impact on the firm’s cash f lows can thereby be estimated (e.g., A /R balance can be computed
based on assumption for days sales outstanding). A financial model that integrates those assumptions into the workbook used to project the P&L
forecast should be used so that whenever one assumption changes, its impact on all three financial statements will be computed automatically.
CAPITAL BUDGETING.
The annual capital budget is a list of approved
capital projects and approved dollar amounts. A capital project may consist of either a single item or a group of related purchases that have an expected life in excess of one year and exceed the firm’s minimum dollar value threshold for capital treatment. For reporting purposes, capital is utilized when an irrevocable commitment is made—not when cash is paid or an invoice is prepared by a vendor or received by the firm.
Finance, Accounting, and Human Resources
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In general, a capital budget for a given year covers that fiscal year only. For most firms, there is no automatic carryover of unused budget appropriations.
If a project runs into a new fiscal year, the remaining spending requirement should be separately approved as part of the new fiscal year’s budget.
When developing the capital budget, the same principles discussed earlier for long-range planning and annual budgeting apply, that is, set macrolevel targets within the context of the long-range plan and then have line managers develop the detailed plan within those parameters from the bottom up.
In determining the actual level of capital spending for each department, the following metrics may be helpful in rationing scarce capital resources:
• Capital spending as a percent of projected revenue
• Capital spending per projected headcount
Approval of capital project requests should be based on an analysis of the project’s economic rate of return as measured by an assessment of its net present value (NPV), internal rate of return (IRR), return on investment (ROI), and payback period. Since most capital expenditures in a professional services firm are related to information technology, many justifications for replacement of basic personal computing equipment will not yield a meaningful rate of return analysis. However, larger system development projects should be scrutinized carefully to understand fully not only the initial capital costs involved in developing the system, but also the ongoing operating and maintenance costs related thereto (i.e., the total cost of ownership).
Once a capital project is completed, a postanalysis should be prepared on all material projects to ensure assumptions that supported the original approval of the project in fact yielded benefits set forth in its economic justification analysis. In practice, completion of this important analysis often falls to the bottom of the priority list in favor of more urgent operational matters.
By not insisting on an accounting for each significant project’s actual returns, management bypasses an excellent opportunity to learn from actual experience that may be applied productively to future capital request analyses.
Cost Estimates: Prebilling Authorizations to
Spend Your Client’s Money
Prebilling your clients based on an estimate of future expenses can dramatically improve the firm’s cash f lows. Doing so for profit on the interest earned during the f loat period is not advised because it may significantly impair the relationship with your client. Rather, such billing arrangements should be utilized when the firm is asked to undertake projects for which significant out-of-pocket expenses are required on the client’s behalf. In many cases, the firm may need to move quickly on behalf of the client, often before the client can physically forward the funds needed to cover the expenses. In
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these cases, the firm should establish and enforce a policy that requires written authorization from the client that a certain dollar level of funding has been approved for a specific purpose and that the client will pay that amount before any commitments are made on the client’s behalf. If the firm fails to secure that written approval from the client and the client subsequently changes its mind about the project, the firm may be liable for all such expenses. Thus, it is critical that these authorizations, also referred to as “estimates,” be signed before making any commitments. Finally, the firm should ensure that its written agreement with its client include clear language as to what types of expenses will be reimbursed to minimize any ambiguity that may occur as the assignment unfolds.
Project Cost Accounting
One of the most important factors executive management can monitor and control is the marginal cost of servicing its clients. The value of staff time is the most critical variable factor in determining the total cost of a project and thus must be rationed in accordance with expected revenues. In its simplest form, cost accounting in a professional services environment compares revenue from a client or project against the cost of providing labor, overhead, and nonreimbursed out-of-pocket expenses to the client. Each of those components is allocated as follows: