Budgeting- Part I – Operating Budget

BUDGETING BASICS

You might be lucky enough to be walking into a managerial role where budgeting is managed well.  In some organizations your finance team will hand you monthly reports on what you’re spending against your budget.  And if that applies to you, you’re lucky – that will make your budgeting life much easier.  In many organizations though, managers are thrown in at the deep end and will have to learn to swim!

In assuming a new managerial role, one of the first questions that I have always asked was “What is my budget?”  When I asked that, I could have been asking several things.  Did I mean operating budget?  Did I mean capital budget?   Or did I mean both, as there is a basic, fundamental difference between an operating budget and a capital budget.  When you step into your first management role, it’s likely you won’t know what some of these things mean.  You probably haven’t had to engage with this as an individual contributor.  But it’s not rocket science.   By the end of this primer, you’ll know a whole load more!

When I have asked the question “What is your budget?” to my team members most of them could not answer that question, and therein lies the problem.  Like any other aspect of management, you need to spend time understanding what you are working with when it comes to budgeting.  You need to be clear on what you are spending and earning within your remit so that you can make the best decisions possible.

Any savvy manager should be able to answer the question of ‘What is your budget?’ by stating both an operating budget number versus a capital budget number to give a complete answer.  Other business metrics that are important to know include headcount, operating budget as a per cent of revenues, cost of major projects, number of countries that your business operates in, but I would argue that knowing your budget is the most important of all.

After reading this primer you will know which budget numbers you have to know, and which ones are good to know but of lesser importance.  The more information you have at your fingertips the more informed you will be.  We will first discuss Operating Budgets, then Capital Budgets and then we’ll wrap up with the most important part – your Budget Presentation.

Rule #1:  Always know the numbers – all the numbers.

OPERATING BUDGET

An Operating Budget, also known as an Overhead Budget, is fundamental to running a department.  Items such as salary, training*, software (SW) and hardware (HW) maintenance, consulting*, phone expense, data circuits, equipment rentals, equipment leases and depreciation etc. are all typical operating budget expense items.  Your operating budget is a number that you should always have at your fingertips.

Your operating budget may be a direct corporate overhead expense, it may be allocated back to operating divisions, or it may be a direct charge to operating overhead.  From an accounting perspective it is a charge to the P&L (Profit and Loss) and appropriated to the reporting period (meaning that the expenses need to be accounted for in that period). 

No matter what, this is the basic information you need to run your department efficiently, so this is the one figure you really have to be aware of (keep reading to find out how).

Rule #2:  Always know your Operating Budget number.

In preparing your operating budget, it is important to note that there are items for which you have control and others for which you do not.  Lets’ dive into some of those items and look at how they’ll work in your operating budget.

*  There are circumstances under which these items may be partially or entirely capitalized as opposed to expensed.

Rule #3:  Know which items are controllable vs. those that are not.

SALARY

Salary is a controllable item.  It is controllable in the sense that you can hire and fire staff members, thereby raising or lowering this operating budget expense item.  With some exceptions, salary is usually your largest expense item.  Since departments are not always fully staffed, you will likely come in below budget for this line item because of the positions that are open.  This is called your “vacancy” factor.  Some companies will scrutinize your salary line and look to reduce it because of your vacancy factor.  You should be prepared for this, anticipate it, and even be proactive about it.

Let’s analyze this using a hypothetical situation. If there are 100 employees in your organization and there are on average, at any given time, 10 openings, then your vacancy factor is 10%.  As a result, most financial reviews will result in a 10% reduction in your salary line, spread evenly throughout the year, so be prepared.  You may choose to replace your permanent staff with contractors until you can hire your permanent employee.  You may or may not do this all the time, and you may or may not have these contractors on board the day after your employees leave; nevertheless, budget assumptions need to be made.  These budget assumptions should be spelled out in your budget presentation (we’ll talk about budget presentations a little later in this appendix!).

Continuing with this example, let’s say that you fill 80% of your vacancies (8 positions) with contractors at an average hourly rate of $75 per hour and that these contractors work 40 hours per week.  Your monthly cost is $96,000, which would show up on your contractor expense line.  This line is critical to you because if you are not allowed to budget for contractors when your salary line is decreased, then your organization’s effectiveness is reduced by 10%.  That would need to be reflected in your day-to-day service levels or project plans.  Even in this example, your organizational effectiveness is reduced if you are not planning for replacement of the entire vacancy factor – this is something for you to strongly consider.

Rule #4: Salary vacancy factors need to be offset with contractor expenses or organizational effectiveness is reduced accordingly.

Employee replacement costs are often overlooked.  Even when you have an internal organization dedicated to helping you with your staffing needs, there may be such things as advertising expenses or employee referral awards (expenses), all of which will likely be charged to your budget.  Again, I suggest that you make some budget assumptions.  Staying with our example, if there are 10 people to be replaced (10% vacancy factor) and we assume that 5 are hired through agencies, 3 through advertisements and 2 through paid employee referrals, the annual replacement costs would be:

5 people x $75K (avg. salary) x 20% agency fee	$75,000
3 advertisements at $200 per ad run for 3 wks.	$1,800
2 employee referrals at $1,000 per person	$2,000
Total replacement cost	$78,800

Be prepared to defend your rationale for how hiring gets split across these categories.  History is perhaps the best rationale, but don’t be overly influenced by history as you may find yourself stuck having to repeat it.

And if you are increasing your staff (and therefore the salary line), be prepared to also justify all of your staff additions, using a consistent format to show all staff additions.

For permanent staff working on projects that are capitalized, some organizations choose to capitalize their internal staff in addition to the external staff (consultants and contractors).  If that is the case, start by developing your operating budget based on the number of staff you have and then reduce your operating budget and increase your capital budget according to those working on the projects.

Don’t forget to include salary increases in your salary budget line.  If you are on an annual review system where everyone receives a salary increase at the same time, then your job is easy. If your raise pool is 5% then you increase your salaries by 5% in the month that raises are given.  If raises are based on the date of hire or some other system, then you will need to develop a spreadsheet showing the month of increase and the amount – for budgeting purposes you may just give everyone 5% at the time their raise comes due and determine the actual amounts at the time of increase, or you may be asked to forecast promotions, raises and equity adjustments as a part of the budget process – every company is different in this regard.

BENEFITS

Benefits are an uncontrollable item because once the salary line is established you cannot alter this – it is usually established by the Finance function and is frequently in the 15-30% range of salary.  Benefits include the company portion of such things as medical, dental, vision, and life insurance along with vacation and sick leave.

Although you don’t have to control them, you do need to understand them.  As I’ve said before – you’ve moved to the other side of the table and what you understood as an employee, you now need to see from the other side and understand the impact on the organization.  As an employee you were deriving the benefits of the benefits – as a manager you now need to see the cost of those benefits to the team.

Software and Hardware Maintenance

SW and HW maintenance (or any other forms of maintenance) may or may not be controllable, depending upon whether you have maintenance contracts or not.  It is controllable when an existing commitment does not exist and is uncontrollable when you are locked into an existing contract.  This is often an area for potential savings and is sometimes an area for gross error if you are unaware of existing contracts and don’t have a provision for them in your budget. 

Every department should have a schedule for all maintenance.  Here are the steps for developing one:

Rule #5: Never enter into evergreen contracts.

1. List all HW under your responsibility.
2. List all SW under your responsibility.
3. List all SaaS (Software as a Service) contracts.
4. Other Maintenance contracts
5. For each line item, identify if a contract exists.
6. If a contract exists, identify the term of the contract, the start date, the end date, and the costs noting if the contract renews during the budget period.  Note:  some contracts are “evergreen” contracts meaning that they automatically renew unless you notify the vendor in writing within a specific number of days in advance of the contract end date.  That’s not an ideal contract to get into.  You always want to be notified when a contract is ending, and you want that responsibility to reside with the vendor. It’s important to be aware of and consciously consider every contract before renewal date.  Just like you would with your personal car insurance… shop around for the best deal!
7. If you do not know if there is a contract or cannot locate the contract(s), ask your vendor for a copy of any or all of your agreements with them.  There is nothing wrong in asking – what is wrong is not asking.  If you do not have a contract for the line item you are examining, how are you handling maintenance?  There are three possible answers to this question:
   1. You pay Time & Materials (T&M) – pay as you go at a predefined rate, usually at a higher cost than if you have a maintenance contract.
   2. You self-insure (e.g., for HW you keep spares or repair the equipment yourself; for SW you have access to source code and maintain it yourself).
   3. You don’t know, which is the equivalent of “do nothing.” This means you are unaware of a problem until it needs fixing and don’t pay attention to it from a budget perspective.
8. Every SW and HW contract should be examined periodically, at least at budget time, to determine if it is needed.  This is the time to verify that all HW and SW contracts are active – meaning that the hardware or software is still in service.  You should look at value received when examining maintenance contracts.  You need to understand and recognize when a maintenance contract includes new releases and maintenance releases or is just a break/fix contract.  If it is the latter, you will need to examine your maintenance experience and the age of the equipment for HW contracts.  For SW, you’ll need to know if the contract addresses operating system upgrades and also if you have modified the software so extensively that you cannot stay current with new releases.  “Good business sense” will guide you when examining these contracts whether to:
   1. Go on T&M – you need to recognize that in many T&M contracts your service level parameters with the vendor, e.g., response time, repair time, etc. may be less than if you were on a maintenance contract and only you can decide on the real business value of one versus the other.
   2. Self-insure
   3. Retain a maintenance agreement.
9. Include new capital SW/HW purchases that may require operating expenditures during or after the initial warranty period.

Following this guidance will ensure tidy practice and a smooth transition to whoever steps into your shoes when you move up the ladder.  The ideal scenario is that each manager receives a monthly report from finance that includes the budget, actual, and variance, and that every contract is tracked.  But if that’s not organization wide, you need to do it yourself to ensure that there are no surprises down the line!

Leased Equipment

Leased equipment is a controllable item and one that can often wreak havoc on an operating budget.  It is a controllable item because you make the decision to enter into the leasing contract as an alternative to paying cash and capitalizing an asset.  The reason it can wreak havoc on your operating budget is shown through the following example where you plan to spend $1M on a capital asset in month 3 of the budget year.

BUY:  Assume that the asset is acquired and placed into production (into use) in month 3.  Assuming a 3-year useful life, the depreciation expense starting in month 3 is $1M/36mos = $27,778/mo.

LEASE:  Assume that the asset is leased (using an operating lease) and assume an effective lease interest rate of 10% and the asset has no residual value at the end of the 36-month operating lease, the lease cost in month 3 is $36,111 and will be $36,111 per month for the next 36 months.

Which of these two scenarios is best for you?  In some companies where cash is tight, leasing may be a given and can be planned into your budget from the start.  In other companies that wish to focus on the best financing decision, it may depend upon economic conditions at the time the asset is acquired.  Some vendors offer very attractive leasing terms that cannot be ignored, even if your company is flush with cash.

From your point of view, you will need to pick one and budget for it.  Thereafter, to the extent that what you do differs from what you planned, you will need to explain the variance – for example:

$1M not spent in Capital Expenditures (cash out the door) resulting in a variance of $X dollars for 9 months (for this budget year) of lease expense in your operating budget.  As long as it ties, then this explanation is likely to be acceptable. 

The decision to buy vs. lease is typically a Finance department decision, although some companies choose to delegate that decision-making to the department.  Obviously, you should use your best judgment in making these decisions and do not be afraid to ask for guidance from the Finance department.  Remember that leasing expense is usually viewed as an offset to depreciation, so if you acquire an asset, you will need one or the other in your operating budget.

Rule #6: When in doubt, check with your Finance department.

Training

Training is a controllable expense and is often viewed as discretionary.  In some departments, training which is associated with the launch of a new system can be capitalized, so follow Rule #6 as to what policies your company follows.  Seminars and conferences are sometimes included with training and sometimes they are split out as a separate line item. Training budgets are usually around 5% of the total operating budget and can vary widely from department to department.  It’s a good idea to also include travel expenses for training in the training line item as that will encourage you to look for local or virtual classes whenever possible and helps to represent the true overall cost of training.

Consulting

Consulting is a controllable expense and is one of those items that can fall into different categories depending upon how and where it is used.  It is normally treated as an expense if the consulting project is a study, research, or an investigation of technologies. If the consulting is specific to a project and directly contributes to the creation an asset, it is normally capitalized (we’ll get to capital budget in a moment – remember, it’s the long term budget that will likely be out of your control).  Again, refer to Rule #6, “When in doubt, check with your Finance department.”  It is a good practice to review consulting charges with your Finance department and determine if they should be expensed or capitalized.

Contractors are resources that are often used to substitute for open headcount or to augment existing staff when additional temporary resources are required for day-to-day operations for specific projects or to augment existing staff when specific or unique skill sets are needed.  In most departments, the rules that you apply for accounting for permanent staff apply to the contractors.  Again, refer to Rule #6.

Phone expense

Telephony, which includes fixed and mobile voice and data, has both controllable and uncontrollable elements.  They need to be accounted for in the same manner as maintenance.  A list of all telephony expenses should be developed listing:

1. the identifier (such as phone number or circuit id#)
2. the vendor
3. the monthly charge
4. the primary use (e.g., Internet connectivity or telemarketing)

The list, when completed, should be sorted by vendor and by cost.  As with maintenance, identify if a contract exists, and then record the key elements of the contract such as start and end dates and monthly rates.  If you do not know or cannot locate the contract(s), ask your vendor for a copy of any or all your agreements with them. 

Once you have your list sorted by vendor or by cost, you can negotiate with vendors for new terms, better terms, or combined services.  For example, while vendor A may be providing your 800#’s, vendor B your local data circuits, and vendor C your long-distance circuits, any or all may be able to provide the majority of the services by asking them to bid on them in a bundle.  For longer-term contracts you may be able to reduce rates.  There are provisions that you can put into such contracts to protect yourself in the event of rate decreases or new technology introductions. 

All telephony lines need to be examined to verify that they are active and in use.  When unsure, ask the vendor to assist.  You’ll be surprised when you find lines that are no longer active for which you were paying for the service.

Rule #7: When dropping or adding services with a vendor, always put such requests in writing and keep a copy.

As with maintenance, don’t forget to allow for new business requirements from new projects or for increases in usage due to such things as business expansion, new product rollouts, or the opening of new offices and facilities.

Internet Expense

Internet expense can be either a controllable or uncontrollable expense depending on whether contracts exist or not.  This often shows up under phone expenses, as the ISP (Internet Service Provider) may be your local phone company.  Many companies are also hosting their web servers externally, so that expense may show up here.  Fees for domain names and email services may also show up here rather than as software maintenance.  Try to avoid having Internet expense included in line items such as phone expense as breaking Internet services out into a separate expense category gives this area more visibility, which is especially useful when doing year-over-year comparisons (see Budget Presentation discussion to follow).

Travel and Entertainment

Travel and Entertainment (T&E) is a controllable expense.  Even though it is rarely a significant line item as a percentage of your operating budget, it always seems to draw an incredible amount of scrutiny, as if you were planning an off-site meeting to some tropical island for your entire staff.  The way to survive this scrutiny is to have detailed back-up.  Identify each expense by person, by trip, and by location with appropriate justification.  This is one budget category where year-over-year comparisons and bridges are essential, especially if this category is increasing.  For frequently traveled locations, establish standard rates for airfare, hotels, and meals.   Make your spreadsheet bullet proof and easily modifiable, so if 5 trips are reduced to 4, the recalculation is easy.

Project-related travel should be charged to the project itself if your Finance organization allows it. Travel to conferences, seminars and training should be included in the cost of conferences, seminars, and training and not in the travel expense line item.  Keep your Travel and Entertainment line item clean and focused on general business travel not associated with projects, conferences, training, etc.  While these travel items are all business related, it is best to keep them separated from general business travel required in the performance of business responsibilities.  The less Travel and Entertainment is muddied up the better chance you have of getting it approved.

Employee Activities

Employee Activities are a controllable item and an important part of keeping morale up and turnover down.  As this is an area that will also receive scrutiny, it is useful to demonstrate that you are keeping the costs down.  For example, I always held quarterly all-staff meetings and tried to hold them at locations internally so that the money was spent within the company whenever possible.  This did not necessarily decrease I.T. costs, but it did make me a good corporate citizen helping other departments to meet their budgets (such as food services and facilities).  I also mixed in some employee sponsored events such as potlucks to keep costs down and to demonstrate that it was not always the company footing the bill.

Now that you have all of the main elements of your budget, you need to ask yourself the question “If I did nothing new, if I added no new staff, no new capital equipment, no telephony, etc., etc. and just maintained the ‘status quo,’ what would my operating budget be?  This is what is referred to as “the costs to keep the lights on,” the “fixed cost” or the “do nothing” case.  This number should be viewed both as a total number (e.g., $10M) and as a percentage of your operating budget (e.g., 75%) as it gives more visibility to what part of your operating budget is for growth, expansion, and the cost of inflation.

Rule #8: Always know “the cost to keep the lights on.”

Depreciation Expense

We all know the word depreciation.  It’s when you buy an item, like a car or a phone, and it immediately starts to lose value because it’s now second-hand and getting older (aren’t we all!).  When organizations buy an asset like a $15,000 conference room table for example, it shows up on the balance sheet as an asset. After that it will show up each year as a line item due to its depreciation expense. Even though no cash is outlaid, the value of the asset decreases.  Note:  Most finance organizations establish a threshold for expensing items rather than capitalizing them (e.g. $5K).  So, for example, buying a PC which is an asset, it would be expensed because it costs less than the threshold for capitalizing items.

Depreciation is an uncontrollable expense.  It is the one line item that can really mess up your budget; mainly because you have no control over it – even when you think you do, you don’t.  Always ask your Finance department to tell you what your depreciation run rate is going into the budget period so that then you only need to allow for capital expenditures for the new budget period. 

It’s essential that you understand how your assets are being used, so that you can adjust your depreciation downward for assets whose useful life has been completed during the budget period.  If you fail to account for assets that are retired or fully depreciated, the risk is that your depreciation is overstated.

Other EXPENSE ITEMS

There are other items that are often included in G&A (General and Administrative) expenses that the corporation assigns – items such as Rent (office space), Supplies, Postage, and certain types of Company Insurance like General Liability.  These items will vary from company to company and are usually uncontrolled expenses not directly related to the department items that have already been described.

Operating Budget Summary

In summary, the following table highlights key expense line items and some of the things to watch for and in identifying potential areas for expense savings:

Item	Controllable	Things to watch for potential savings
Salary	Yes	Manage the vacancy factor, employee replacement costs, justifications for staff additions, annual salary increases
Benefits	No	Include it
Software and Hardware Maintenance	Yes and No	Identify all HW and SW and associated maintenance contracts; avoid evergreen contracts; establish value of contracts; include new capital purchases requiring maintenance
Leased Equipment	Yes	Establish buy vs. lease criteria and try to anticipate
Training	Yes	Include travel costs
Consulting	Yes	Determine if it is an expense item or a capital (depreciable) item?
Phone	Yes and No	Identify all voice and data lines; look for inactive lines; include new business requirements
Internet	Yes	Keep separate from phone expense
Travel & Entertainment	Yes	Have detailed back-up materials
Employee Activities	Yes	Keep costs down; be a good corporate citizen
Depreciation Expense	No	Obtain run rate from Finance department
Other	No (mostly)	Include them if known