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Budgeting Season: Best Articles on Budgeting

Like every year, the end of summer marks for me the beginning of the budgeting season. Many organizations start their planning processes in August or latest September. For management accountants and other planners, it is a tough time. On top of the normal workload, a solid budget needs to be prepared.

Budgeting season articles by hotspotfinance

To help you get started with the budgeting season, we recently published some valuable articles like:

5 Secrets to Optimise a Corporate Budgeting Process

4 Tips to Finish Business Budget Planning on Time

How to Set up an Efficient Budgetary Control Process

Interesting 3rd party articles

We also noticed some top articles from other authors which could provide great value for management accountants. Below you find a selection of 4 must reads before you start the budgeting season.

 

I like the following article written by Patricia Lotich because it goes further than just explaining the budgeting process. It makes the so important reference to strategic planning and how the budget can be used for variances analysis. A good guide how to proceed with the budget that applies for small and larger companies.

10 Steps to Developing and Managing a Budget

 

The next article I recommend reading is written by Gene Siciliano and focuses on budgeting tips for business owners. It first explains that many businesses don’t use budgets and shows some benefits of actually using them. Although aimed to help small business budgeters, these 8 tips are generally valid.

8 Budgeting Tips for Your Business

 

The next article I recommend is written by George Braun and brings up the strategic aspect. Do you have some plans for the future of your business? Good! When preparing your budget, make sure that these plans are incorporated. A budget is only a financial representation of the future and it should follow your strategic plans.

6 Helpful Tips For More Strategic Business Budgeting

 

The following article provides an informative introduction to the problems companies face with the budgeting process. Gary Cokins and Michael Coveney’s article then goes further and introduces a model explaining the maturity of budgeting within a company. In my eyes, this is a very informative read for all management accountants.

Developing a plan for better planning

 

All the best preparing your budget. Please share your thoughts about the upcoming budgeting season with us.

If you know a valuable article that could be a nice addition to this list, let me know.

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4 Tips to Finish Business Budget Planning on Time

Those operating businesses understand the variety of important tasks that need attention on a regular basis. Keeping up with items that may not be a featured part of the business can be difficult. It is not easy to make time for everything every day. Whilst business budget planning is set in the cooperate processes of larger companies, the task is often overlooked by small businesses owners.

Businesses leaders know their time is valuable, and fitting extra activities into an already full day takes a lot of effort. However, business budget planning is an essential part of every business, no matter what the focus of the business is or where the business operates. All businesses, large and small, need to set aside time for this. Knowing and understanding the business’ goals keeps all staff working in the same direction and allows for success.

In the article Lean Finance: 4 Awesome Tips for Busy Mgmt Accountants I outline how I manage to save time whilst producing a good result. The following 4 tips will go a bit more into detail and help you finish your business budget planning on time.

Plan time

Business budget planning will be easier and less stressful if a reasonable timeline is established and followed. Make sure that you know your deadlines (for example handing in the final budget) way in advance. With this information, you can start planning your time backwards. Make sure that you incorporate enough time to prepare, discuss and review the budget or parts of it.

Personally, I use to already block the time in my calendar to make sure I can allocate proper budgeting time later (see tip 3). I also book time slots in all managers’ calendars for planning meetings (tip 4). It could be very stressful later on if you are unable to get hold of an important person. Therefore, I highly recommend booking meetings as much in advance as possible.

Tools

Often, the tools used to keep track of the budget cause the business budget planning session to be difficult and frustrating. Some business owners and managers still prefer the use of a spreadsheet and a pencil for budget planning. On the one hand, we should accept individual preferences. On the other hand, we should make sure that the most efficient tools available within the company are actually used. This can save valuable time and thus speed up the whole process.

I recommend taking a lead position and defining in which form and tool inputs need to be handed in. Think about it in advance and already prepare planning tools as templates.

Time slot allocation

It is common for interruptions to occur during budget planning. Even the best-organized planning sessions can become ineffective or even useless if interruptions frequently stop the session. This is why planning is important. Honestly, assess the business for potential time drains. This can include, but is not limited to, the structure of the business, the type of technology used to review the budget, and personnel who commonly mismanage time. Knowing in advance, what may interrupt a budget planning session can help alleviate the situation, even stopping it before there is an issue.

For my individual work on budgets, I block the time in my calendar and make sure that I work on the business budget planning and on nothing else. Focus is the key. Multitasking will divert your focus, so try to avoid it. Don’t check emails, simply leave them for later. The aim is not to get interrupted at all for the duration of your planned session. My planning sessions are normally topic related and last for 1-2 hours.

Planning meeting

Planning meetings have been proven to be very powerful. I personally aim to sit together with every single manager of a profit or cost centre. We then determine the budget for the next period together. At the end of the meeting, we both have the same view on the topic and have some stable figures for the budget. If needed some more research on a topic will be done but in most cases, I manage to finish the meeting with a solid budget in my hand.

In order to achieve a productive meeting I recommend preparing your budgeting tool in advance, mark critical points and already send these point to the manager in advance. Doing so, we can ensure that all the information needed at the meeting is actually gathered before.

Conclusion of business budget planning

To summarize, problems and circumstances that hinder timely budget planning can easily happen. To avoid losing valuable time and to present a completed budget in a timely manner, it is necessary to understand the business and the employees. With careful examination, budget planning can be more simple and completed in a timely manner.

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4 Tips for Efficiently Forecasting Financial Statements

Forecasting financial statements is an important financial task. Done one to several times during a year, it allows getting a realistic picture of the yearly outcome. It shows management what revenues, costs and profits they can really expect at the end of the year.

Forecasting financial statements also brings the benefit that action can be taken to improve performance. For example, labour was budgeted to be $ 2 Mio for the current year. The actual forecast done in May indicated labour the reach $ 2.3 Mio. This insight gives management the time to initiate some correction or provide some justification.

Here come the 4 tips that will help you efficiently forecasting financial statements:

List of the actual 4 tips to efficiantly forecast financial statements

1. Apply variance analysis

Use budget vs actual (variance analysis) in order to check past performance. There are different ways of handling this. Either you have noticed during the past that there are some deviations or you find out when you actually compare actuals vs plan for the forecast. For example, if you had budgeted earlier that you will be selling 600 luxury watches within a given period of time but you end up selling 280, then it is appropriate to adjust your forecast. Make sure that you only focus on the main revenues and costs items. Get lost in details means losing valuable time and this is exactly what we try to avoid.

2. Know your business and what drives it

This bottom-up approach encourages the use of revenue and cost drivers for forecasting financial statements. Use these drivers to adjust the cost according to the predicted level of production or sales. This approach will assure that you are not going to plan every single detail but you adjust the costs based on a change of the output. For example, the output is supposed to increase from 1’000 items to 1’200 items. You are not planning all relevant costs again but you take the costs from before, divide it by the original output of 1’000 items and multiply it by the increased output of 1’200.

In the past, I even used a scale from 0 to 1 which I attributed to the main cost factors of a product to indicate its variable part. This allowed differentiating the cost changes based on my assumption of variable vs fixed costs. You can look at this driver metric approach as an advanced level of variance analysis (tip 1).

3. Make forecasting financial statements simple

The fundamental of efficiently forecasting financial statements lies in keeping things simple and clear. Apply driver metrics as described in tip 2 and perform a rough variance analysis as described in tip 1. That is all. Now, you should accept that you don’t plan all other things into detail. Administration costs, for example, you can simply leave at the previous level and not touch them at all. If you expect major changes, apply the really big ones to it but if you are not sure or only expect small changes, just leave it. Keep the article Lean Finance: 4 Awesome Tips for Busy Mgmt Accountants in mind where we talked about the Pareto rule and accepting the gap.

4. Use the right tools

You can create a good forecast if you use the right tools that will enable you to enter or make adjustments to your forecast whenever it is deemed necessary. Choose an appropriate workspace for you. For example a spreadsheet or database framework. Accounting software sometimes comes with automated features and reporting capabilities can be used since they will let you analyze historical data to help you create a forecast. Personally, I use self-designed spreadsheets to make and document my changes before uploading the figures back to the company-wide accounting software. It is all about finding the way that works best for you.

Conclusion

Forecasting financial statements is not only an important task but can also be time-consuming for a management accountant. The 4 tips provided aim to reduce the required time whilst still producing a good and insightful work.

Fancy sharing your experience in this area? Have a go and comment.

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How to Set up an Efficient Budgetary Control Process

What value has a budget if there isn’t any budgetary control process established? No value at all. Well, maybe some but surely it is far away from being at high level.

The aim of a budgetary control process is to measure the level of budget deviation, take action, track action and eventually provide insight to adjust a budget value (see also the article budget vs actual for more information about key benefits of variance analysis).

An efficient budgetary control process can easily be set up following these easy five steps:

list of the five steps required to build up a budgetary controll process

Define control intervals

First of all, you should think how often a comparison between actual values and budget makes sense. Keep also in mind that you actually need to be able to collect the relevant data. For example, a weekly financial comparison could be impossible if figures are only published on a monthly base. A common interval is monthly.

Define comparison values

You should then define against which plan version your actual figures are compared to. You could use the budget for the fist some months and then switch to a forecast version or stay with the budget for the whole year. Your comparison values really depend on how the company you work for is set up. As a rule of thumb, compare to what managers get measured at.

Set up a standard report

After you know your intervals and the comparison values, you should set up a standard report for your budgetary control process. Design your report and make sure you can replicate it without hassle for all your intervals. This could mean you initially spend some time preparing it but it will save you of repetitive creation later on. The article how to design a variance analysis report assists you producing an easy to understand report.

Define audience and means of communication

After all, you should consider who should receive your report. Depending on your comparison you may include one to several people. Make sure the report goes only to those people who have a real interest in it. On top of that, figure out the best means of communication. Do you simply send an email with your report or is it more efficient to arrange meetings. If results are not completely clear or measures need to be decided, a meeting is more promising than written communication.

Track agreed actions

Don’t forget to note down, initiate and track any measures that were agreed on. This part is essential for a successful budgetary control process. Make sure that at the next control interval you discuss the progress towards the agreed actions and their impact.

And the budgetary control process is set up

The five steps above will help you setting up an efficient control process and thus add value to the business. Keep in mind that your result depends on the quality of the used plan values. If the plan was of low quality, your control won’t be promising neither.

 

 

Let me know how this works for you. Feel also free to share your way of creating a budgetary control process.

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KPI Report Template: Lean & Effective Financal Control

The aim of this article is to show how two aspects, namely KPI trees and simplification (lean finance), can be combined to develop a powerful KPI report template. In a previous article, we already discussed how a KPI tree can be designed. Now we go a step further and develop a clear and easy to understand KPI tree (or KPI report template) for an e-commerce business. Whilst doing that we keep in mind that we aim to practice a lean finance approach.

Basics of a KPI report template

To develop the KPI report template use the actual business model as the main logics behind all the figures. As business models can be very different from industry to industry or even within the industry, there isn’t the one general right report. Let’s assume we are management accountants in an e-commerce business. We could use the following logic on the income site:

Visits on the site x conversion rate x selling price

There is an amount of monthly visits to our site. From all these visitors some just browse around but some decide to buy our product. In other words, they convert and buy one of our products at a given price.

On the cost side, we could assume that the product itself has some costs (for example our purchasing price), we need to spend a certain amount on marketing for each unit sold and we have some fixed costs like employees or rent. Thus, we can use the following formula:

Fixed costs + units sold x (product costs + marketing costs)

As we try to generate a lean model, we may not cover every little detail of the business. However, we end up with a KPI report template that includes the main parts and interrelations and thus provides a result in line with the Pareto principle (with 20 % of the time, we cover 80 % of the correct logic).

KPI report template for e-commerce

Using the thoughts from above, we can now produce a KPI report template, putting income and cost side together. This could look like this:

KPI report template for an e-commerce business

Now you can simply add the relevant values to each box. I would recommend that you also use colors to indicate how favourable a value is. For example, indicate a rather bad value with a red box or a good one with green. If you have budgeted values, you can even include a deviation. Your result may look like this:

KPI report template for an e-commerce business including example figures

 

Everybody can see within seconds where the business is doing well and where not. Thus, the report can now be used to analyse and steer the business on an ongoing base.

Advantages

There are several advantages of using such a KPI report template. Firstly, it gives an overview of how successful the whole business is currently operating. Is the company producing a decent profit, is the conversation rate high enough, etc. Secondly, it makes it easy to understand the main drivers of the business and their basic interrelations. Thus, the KPI report template helps to find areas for improvement. Thirdly, although being a high-level report, it is always possible to deep dive in an area where room for improvement is assumed. Finally, it is a great result of lean finance. One report is generated that can be used to steer the business at the top level.

Conclusion

An actively used KPI report template can be a valuable reporting instrument with many advantages. Because it is based on the business model, it represents the company’s trading, showing basic factors and their interrelations.

 

Please feel free to share your experience in this field with me. If you haven’t tried it out yet, give it a go and let me know how it worked.

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Lean Email Communication for Efficient Management Accountants

Emails have increased drastically and its role as the main communication tool is long established. However, many email communications are not efficient and just occupy our valuable time. In this article, we will have a look how management accountants can adapt a lean email communication and thus be more efficient. If you strive for a general lean approach of work, check our lean finance post.
Work email can easily eat up 15 – 20 % of an employee’s time because you end in a copy of an irrelevant email, formulations are unclear, the purpose is vague, email is the wrong means of communication and so on.
At every company I worked with, email culture was a topic. It seems people, or at least a large amount of them, are not able to communicate with emails in a satisfying way. As a result, guidelines were developed to increase the email efficiency.

lean email communication graphic for illustration

Lean email communication for sending emails

Here are my personal lean email communication tips for management accountants:

  •  Limit recipients: Limit the number of people you send the email to only those who actually really need to receive it. Often I see many people in the CC field. This is not lean email communication. Leave the CC as much as you can. For example, you are asked to send a finance report, send it only to the person who asked. No need to include your boss or other management accountants.
  • Pyramidal: Imagine yourself in the position of receiving a long and unstructured email. Not really what you like, especially when you are busy. So make sure your email is short, containing the relevant information but short. I personally recommend a pyramidal structure. In the beginning, you summarize the issue on a top level. Later in the message, you can add some more detailed info. If a manager asks you, for example, for his budget of a certain position, answer it right in the beginning. Add details, if really needed, in the next paragraph and probably attach an excel file with the budget details.
  • Make purpose clear: How often have you received messages and asked yourself what does this guy expect from me now. Make sure when you write an email that it is absolutely clear what your intention is. Do you expect an answer to a question, are you only informing, are you asking for advice? Bring your clear question right after your summary at the beginning and probably in the subject line.
  • Clear subject line: The first thing people see is the subject line. Make sure your email can be categorized and prioritized by only reading the subject line. I personally like to add at the beginning words like FYI (for your information), task, advice needed or similar.

Receiving and checking email

Lean email communication also includes how you handle incoming email. Here are some tips how you can be more efficient:

  • Switch off email notifications
  • Read your emails in bulks, for example twice a day
  • Immediately replay when bulk reading if it can be done in one or two minutes. If it takes work, schedule it up and go to the next email.

And in the end?

Applying the points above, you surely get more efficient and work towards a lean email communication. You can’t directly change your colleagues’ habits but tell them how you do it and how you save time. This should also motivate them to give it a try. I’m sure your new way of emailing will be appreciated by many busy managers.

 

Fancy sharing your experience? Have a go.

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Lean Finance: 4 Awesome Tips for Busy Mgmt Accountants

Everyone remembers those moments when you work and work and in the end, you feel like you were not able to add some real value. In this post, we have a close look at the topic of lean finance. What can be done more efficient? Are we even working effectively? What can be completely left to have more time for other things?

Management accountants have a broad range of tasks and they are certainly an important knowledge resource of a company. So you may think it could be difficult to identify possible areas for improvement. Below I produced a list with 4 tips to a hassle free start with your lean finance:

#1 Optimise numbers of reports

As a management accountant, you produce many reports. Take the time to go through those reports and ask yourself two questions:

  • Is this report important for steering the business / unit / department?
  • How much time do I need to prepare it?

Prepare a list showing the results of all your reports. Reports classified as unimportant you either stop sending (my favourite. Just try it out and see what happens. If people complain, you can always find an excuse and send it again), tell the receivers you are currently over busy and you can’t produce it anymore (and never send it again) or try to figure out what the receiver really wants to know with the report and then find out how to improve it.

When going through your list, start with the reports using most of your time. If you can skip only a few you already gain valuable time. You can’t believe how many reports are produced just because they were important 1, 2 or 3 years ago. I’m sure you find some lean finance potential here.

#2 Automatization

Automatization is about producing the same or nearly the same output as before but you drastically reduce your own time needed. Say you have a report where you add values together from different sources. You spend valuable time doing that but technically it could be done by a system or a script.

Get back your list from the first point of lean finance. Now have a look at those reports that consume much of your time and are important.

I recommend that you try automatization even when you now there is an initial effort needed. I personally, for example, wrote VBA Script in excel formatting my variance analysis reports I use on a monthly base. My initial effort was 1-2 hours but every month during the reporting time (when I am very busy) I save half an hour formatting and preparing my Excel files.

The matrix below summarises the first two tips.

Matrix showing 4 lean finance options

#3 Clear and smooth budgeting process

Another area you can apply lean finance to is the budgeting process. In a previous article, I already highlighted how budgeting can be optimised. Here I would like to tell you how I save my own resources but still produce a good result.

  • Make yourself familiar with the budgeting schedule in advanced
  • Read guidelines, make sure to clarify if needed
  • Plan backwards from handing in the budget to the current date
  • Reserve time for yourself for last minute adjustments just before handing in
  • Leave enough time for yourself to consolidate or type in figures to the planning system
  • Arrange a budgeting meeting with every single responsible cost or profit centre manager. Make sure when you walk out of every of these meetings, that you nailed to budget with them.
  • Write a clear message to invite the managers for the meeting and ask them to properly prepare. Make clear that the aim of the meeting is to finalise the budget. I personally already add a draft budget to this message.
  • Make sure you have an easy to use budgeting tool. So you can record and present the results during the meetings

 

The graphic shows how I plan the budgeting process.

budgeting timeline

Take my way to lean finance budgeting and adapt it so it suits you. I am sure you are able to save yourself time and lots of hassle.

#4 Accept the gap

Finally, we should have a look at a topic that is hard to mentally implement but is very powerful. Accept the gap. As a management accountant, you are likely to strive for perfection, you are the person who knows about the cost and revenue, you are the one staff ask about finance topics. A major step towards lean finance is that you accept, that you can’t do everything, know everything, control everything. Simply accept the gap.

I am sure you know about Vilfredo Pareto and his distribution law (also called Pareto law). Adapting his view to your work, we can conclude that you need 20 % of the time to reach an 80 % result. Set your mind and try to strive for the 80 % right solution and you are able to be way more efficient. This will free up the time to go after other important topics or alternatively reduce your overtime balance.

Lean Finance Conclusion

In this post, we had a look at four tips to implement your personal lean finance. It is surely a good start to implement the tips but should not forget that lean finance is a continuous process and not a one-time action.

 

Let me know how it goes for you. Please share.

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Proven Cost Accounting Concepts

Cost accounting can be seen as the whole process of recording costs in order to support management decision. To maximise its effects, companies use individually designed cost accounting concepts. In this post, I will present a short theoretical overview before showing two examples of such concepts. If you are interested in reading more about how management accounting aids decision makers you should head to the relevant article.

Cost accounting concepts in theory

Classical theory teaches us that cost can be differentiated, among others, by its type. On the one hand, there are variable costs. This type increases when the number of products produced rises. A good example is a material used to manufacture a product. On the other hand, fixed costs are present. These costs do not vary when the level of production changes, e.g. rent of an office.

This view can now be broken down from the whole company to its products. Costs and revenues can be allocated to single products and this then allows to produce profitability reports for single products. Below is a graphical example showing the two types of cost, the sum of it (total costs) and the revenue generated. In this example, 500 sold units will make up for the total cost. This point is also called break-even.

Diagramm showing a total cost analysis as part of cost accounting concepts

Example of cost accounting concepts

I would like to show two completely different approaches to cost accounting concepts I have seen so far in practice.

The first example is drawn from a classical industry business. A final product was not only technically but also on the paper broken down in single pieces which all had price tags. The necessary amount of labour to manufacture all these pieces together was also defined and its cost was added. All prices to manufacture a product were collected like this. Having the price of a good (variable costs), we simply added a margin for overheads and profit on top to reach the desired sales price and the minimum sales price (variable costs covered + a little uplift).

The second example is related to e-business. The approach is completely different to the first one where the pricing was product based. The market situation, customer demands, and the current competition is analysed to determine possible products and a market price. The products and prices are adjusted when market movements require it. The cost structure of this company is fundamentally different from the industry business in the first example because all costs (or at least nearly all) are fixed costs.

In theory, a company’s strategic focus can be divided between product orientation and market orientation. This also requires a different approach to cost accounting concepts. The two examples highlighted exactly that.

Conclusion

As a management accountant you should be familiar with the different parts of cost accounting concepts (variable costs, marginal cost, etc). For your work you also need to understand whether your company is rather product or market orientated. In a product orientated company you will spend more time calculating supposed and actual production costs. Whereas in a market orientated company you will rather focus on how your position on the market is and whether this allows providing the required return.

 

Fancy sharing your own experience? I would gladly appreciate your comment.

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How to Design a Variance Analysis Report the Right Way

Calculating variances and producing a variance analysis report is one of the major tasks of management accounting. This post will show how such a report can be designed to be most effective for its receiver. Check our previous posts, if you are looking for variance analysis formulas or the benefits of variance analysis.

Why designing is important

Before exploring the different aspects that make variance analysis reports good in quality, it is essential to understand their importance. Producing such a report may be a standard task for a management accounting, however, the result of it can be of major impact. If a manager receives the report, he or she will base decisions on it. Imagine a document states a certain profit centre returns an unexpected loss instead of a profit. This could cause the manager to start cost cutting.

Another factor to consider is the limited time available for management to deal with the report. It is, therefore, possible that crucial information is missed and wrong consequences are taken. Management accounting needs to make sure this doesn’t happen.

Designing a variance analysis report

State plan and state actual

The first point sounds obvious: The report should state the desired / planned value as well as the actual value of each account or category. Although the document is called variance analysis report, it is of great value to show the two figures which finally lead to the calculated value.

I have seen reports stating more than one planned values for each account. Take care when doing this. You may see this as an advantage because you provide more information but it can lead to confusion. I recommend sticking to one planned value.

A quite neat option is to provide “year to date” and “monthly” columns but using the same underlying planning version. Here an example with “budget” being the underlying plan.

basic variance analysis report showing ytd and actual month

Show difference absolute and in %

As a management accountant one of your aims should be producing a reader-friendly report. Showing the variance in absolute terms and in % provides a good set of information but still leaves the report in a compact format. Check the example from above. For example, the current month product x sales are $ 41’000 compared to a budget of $ 40’000 what results in a variance of $ 1’000 or 3 %.

Showing the variance in % allows the reader to interpret the differences in another way. Someone may say, a variance of 5 % can just happen due to planning inaccuracy and thus is only interested in higher deviations. It furthermore allows the management accountant who is producing the report to quickly gather major differences.

Granularity

When producing a report you should always ask yourself who the main receiver will be. It then should be your aim to produce a report in an adequate granularity. Let’s look at an example. A product manager of product x may be interested seeing each little account which was used to generate his or her product x. The head of all products, on the other hand, is primarily interested in seeing whether the overall production cost is in line with the plan.

I recommend determining the best granularity in a 1:1 meeting with the receiver and then continuously producing the report as discussed.

Use colours for deviation or graphs

A nice way of giving your variation analysis report the extra nudge is by colouring the variances according to their significance. You could use conditional formatting in excel to make this a quick step. Using colours allows you to draw attention (and this can be very limited as described before) on certain accounts which perform well or bad.

Another option is to use graphs. Some managers prefer visualisation over pure figures. This choice is more likely to be used when producing a dashboard or if your report focused on only some accounts. Alternatively, when having many different accounts, it can be applied to the total values only. For example, there are 5 different costs but only total cost is represented in a graph.

Use comments to give insight

After following all the steps before, you produced a variance analysis report. Now it is time to add extra value to it by commenting on core deviations. Use your understanding of the business to produce this kind of useful insight. If variances can’t be explained, the management accountant should analyse accounts in depth or ask people from operations.

In situations where I can’t explain results and can’t get a quick feedback from operations, I personally like to comment “deep dive ongoing”. This gives me time to analyse the issue after sending out the report and also lets the receiver know that examination is in progress. In some cases, you even get possible explanations from the report receiver.

Conclusion

This article highlighted five points that should be considered by management accountants when designing a variance analysis report. Its design is essential in order to maximise its effect on management. Following you find a possible extract of such a report:

best practice variance analysis report based on authors own experiance

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5 Types of Powerful Financial Forecasting Models

Financial forecasting takes the data gained by financial analysis and uses it to make predictions about future cost, profit and growth direction in the corporate environment. In a previous article, it was shown that budgeting is a major task of management accounting. This kind of foreseeing the future not only includes classical yearly budgeting but can also mean monthly or quarterly forecasts. Corporate financial forecasting looks at specific business activities (if not the whole business) such as sales, marketing, technology investments and intellectual property assets to make predictions about future outcomes from those activities over given time frames. The overlap between financial forecasting models, that includes statistics, numerical processing methods, physics, the social sciences and computing has made it one of the most commonly studied fields in business graduate programs and major investment firms.

Prediction making always comes with uncertainties. The development of underlying factors can be unpredictable or hard to estimate. This makes it difficult to provide an accurate forecast. However, several disciplines have converged to provide robust techniques that take business and economic data and return very useful financial forecasting models. In this article, we discuss 5 top financial forecasting models used by businesses.

5 financial forecasting models

Top-Down Models

When evaluating a new business opportunity for which no private sales data yet exists, top-down modeling enables business financial analysts to make predictions about the specific opportunity based on the size of the new market and forecasts about how much of that new market they will be able to cover. Top-down models are useful when exploring the market share that new product lines will be able to grab as well as predicting the impact that introducing new products into established markets will have. Business finance analysts use the top-down approach to test the viability and strength of new growth potential opportunities.

Furthermore, such models can be used to provide a high-level forecast. For example, a company wants to project its financial outcomes on a monthly base. It is then likely that such a forecast is done top-down, adjusting simply some underlying triggers like growth in %. This process saves time compared to bottom-up planning.

Bottom-Up Models

Bottom-up modeling is used in situations where data is plentiful. The primary inputs into this model are the known values associated with each sale and variable volume scenarios. Due to its use of actual data, this approach can produce much more accurate results than top-down financial forecasting models. However, it is also more time consuming and involves more people. This approach is normally used to prepare a sound financial budget based on actual results, inside knowledge and future expectations. Due to its resource insensitivity, the use of it in forecasting is normally limited to one to three planning cycles in a year.

Correlation Modeling

This financial forecasting technique looks at the relationships between two different variables in order to understand the relationship of how fluctuations in one cause changes in the other. Correlation modeling is probably the most widely used predictive model in finance modeling. Its strength lies primarily in its ability to predict the movement in both the same and opposite directions of the business activities it is used to investigate. This approach is used by corporate financial decision-makers to understand their operation’s supply and demand, and price and cost metric curves. It also suggests resource allocation in scenarios where there is a strong pairing of business events but no clear cut cause-effect relationship, such as in changes in sales following new marketing campaigns.

Quantitative Models

Also referred to as statistical models, quantitative approaches are used to establish relationships between the equations of other disciplines as a means of corporate financial forecasting. Popular methods involve Gaussian distribution analysis that takes the results from a set of financial inputs and attempts to fit it to the standard distribution curve to understand sales and profitability. Even when the Gaussian curve does not function as a strong forecasting tool, the model itself is still useful for examining other factors such as the standard deviation and variance of the financial data under consideration. These figures can help businesses understand how their efforts compare in return to their competitors and the averages in their industries. Two familiar examples of how normal curve distribution is used in the corporate environment predictions are in setting inventory ordering thresholds and sales forecasting.

Power Laws

The methods so far have become steadily more technical in their understanding. Power laws are by far the most challenging, though most promising numerical analysis method used in financial forecasting models. Power laws use mathematical functions that describe the proportional movement between two assets. A familiar example from geometry is that by doubling the length of the sides of a square, its area increases four-fold. Power laws are used in corporate financial forecasting models to describe returns from internal business activities. In the stock market, their value lies in their ability to show the breakdown of specific momentum trends after a trading time lapse of only a few minutes. However, corporate use of this technique is to demonstrate longer term earnings trends and baseline return to profitability levels following the impact of significant external events. The technique helps internal financial analysts understand earnings as they relate to the inputs to which they are paired when building this type of forecast model. The understanding obtained from this approach is used to direct resource allocation, capital purchases, marketing and other types of internal investment business decisions.

Summary

Financial forecasting is a discipline comprised of several types of approaches, each of which is valuable depending on the type of financial forecasting being performed and the desired goal of the business financial analyst. This article explored 5 types of powerful financial forecasting models used every day by corporate finance professionals. While no single approach can be used across every type of financial data, the application of several can greatly assist business managers to better understand their sales cycles and to predict the impact that making changes in their resource allocations will have on their earnings.