# Budgeting Revisited

### Introduction

Budgeting is one area that is well suited for Monte Carlo Simulation. Budgeting involves personal judgments about future values of large number of variables like; sales, prices, wages, down- time, error rates, exchange rates etc. – variables that describes the nature of the business.

Everyone that has been involved in a budgeting process knows that it is an exercise in uncertainty; however it is seldom described in this way and even more seldom is uncertainty actually calculated as an integrated part of the budget.

Good budgeting practices are structured to minimize errors and inconsistencies, drawing in all the necessary participants to contribute their business experience and the perspective of each department. Best practice in budgeting entails a mixture of top-down guidelines and standards, combined with bottom-up individual knowledge and experience.

Excel, the de facto tool for budgeting, is a powerful personal productivity tool. Its current capabilities, however, are often inadequate to support the critical nature of budgeting and forecasting. There will come a point when a company’s reliance on spreadsheets for budgeting leads to severely ineffective decision-making, lost productivity and lost opportunities.

Spreadsheets can accommodate many tasks – but, over time, some of the models running in Excel may grow too big for the spreadsheet application. Programming in a spreadsheet model often requires embedded assumptions, complex macros, creating opportunities for formula errors and broken links between workbooks.

It is common for spreadsheet budget models and their intricacies to be known and maintained by a single person who becomes a vulnerability point with no backup. And there are other maintenance and usage issues:

A. Spreadsheet budget models are difficult to distribute and even more difficult to collect and consolidate.

B. Data confidentiality is almost impossible to maintain in spreadsheets, which are not designed to hide or expose data based upon each user’s role.

C. Financial statements are usually not fully integrated leaving little basis for decision making.

These are serious drawbacks for corporate governance and make the audit process more difficult.

This is a few of many reasons why we use a dedicated simulation language for our models that specifically do not mix data and code.

### The budget model

In practice budgeting can be performed on different levels:

1. Cash Flow

2. EBITDA

3. EBIT

4. Profit or

5. Company value.

The most efficient is on EBITDA level, since taxes, depreciation and amortization on the short-term is mostly given. This is also the level where consolidation of daughter companies easiest is achieved. An EBITDA model describing the firm’s operations can again be used as a subroutine for more detailed and encompassing analysis thru P&L and Balance simulation.

The aim will then to estimate of the firm’s equity value and is probability distribution. This can again be used for strategy selection etc.

### Forecasting

In today’s fast moving and highly uncertain markets, forecasting have become the single most important element of the budget process.

Forecasting or predictive analytics can best be described as statistic modeling enabling prediction of future events or results, using present and past information and data.

- Forecasts must integrate both external and internal cost and value drivers of the business.
- Absolute forecast accuracy (i.e. small confidence intervals) is less important than the insight about how current decisions and likely future events will interact to form the result.
- Detail does not equal accuracy with respect to forecasts.
- The forecast is often less important than the assumptions and variables that underpin it – those are the things that should be traced to provide advance warning.
- Never relay on single point or scenario forecasting.

All uncertainty about the market sizes, market shares, cost and prices, interest rates, exchange rates and taxes etc. – and their correlation will finally end up contributing to the uncertainty in the firm’s budget forecasts.

### The EBITDA model

The EBITDA model have to be detailed enough to capture all important cost and value drivers, but simple enough to be easy to update with new data and assumptions.

Input to the model can come from different sources; any internal reporting system or spread sheet. The easiest way to communicate with the model is by using Excel spread sheet – templates.

Such templates will be pre-defined in the sense that the information the model needs is on a pre-determined place in the workbook. This makes it easy if the budgets for daughter companies is reported (and consolidated) in a common system (e.g. SAP) and can ‘dump’ onto an excel spread sheet. If the budgets are communicated directly to head office or the mother company then they can be read directly by the model.

### Standalone models and dedicated subroutines

We usually construct our EBITDA models so that they can be used both as a standalone model and as a subroutine for balance simulation. The model can then be used both for short term budgeting and long-term EBITDA forecasting and simulation and for short/long term balance forecasting and simulation. This means that the same model can be efficiently reused in different contexts.

Rolling budgets and forecast

The EBITDA model can be constructed to give rolling forecast based on updated monthly or quarterly values, taking into consideration the seasonality of the operations. This will give new forecasts (new budget) for the remaining of the year and/or the next twelve month. By forecasts we again mean the probability distributions for the budget variables.

Even if the variables have not changed, the fact that we move towards the end of the year will reduce the uncertainty of if the end year results and also for the forecast for the next twelve month.

### Uncertainty

The most important part of budgeting with Monte Carlo simulation is assessment of the uncertainty in the budgeted (forecasted) cost and value drivers. This uncertainty is given as the most likely value (usually the budget figure) and the interval where it is assessed with a high degree of confidence (approx. 95%) to fall.

We will then use these lower and upper limits (5% and 95%) for sales, prices and other budget items and the budget values as indicators of the shape of the probability distributions for the individual budget items. Together they described the range and uncertainty in the EBITDA forecasts.

This gives us the opportunity to simulate (Monte Carlo) a number of possible outcomes – by a large number of runs of the model, usually 1000 – of net revenue, operating expenses and finally EBITDA. This again will give us their probability distributions

Most managers and their staff have, based on experience, a good grasp of the range in which the values of their variables will fall. It is not based on any precise computation but is a reasonable assessment by knowledgeable persons. Selecting the budget value however is more difficult. Should it be the “mean”

or the “most likely value” or should the manager just delegate fixing of the values to the responsible departments?

Now we know that the budget values might be biased by a number of reasons – simplest by bonus schemes etc. – and that budgets based on average assumptions are wrong on average .

This is therefore where the individual mangers intent and culture will be manifested, and it is here the greatest learning effect for both the managers and the mother company will be, as under-budgeting and overconfidence will stand out as excessive large deviations from the model calculated expected value (probability weighted average over the interval).

### Output

The output from the Monte Carlo simulation will be in the form of graphs that puts all run’s in the simulation together to form the cumulative distribution for the operating expenses (red line):

In the figure we have computed the frequencies of observed (simulated) values for operating expenses (blue frequency plot) – the x-axis gives the operating expenses and the left y-axis the frequency. By summing up from left to right we can compute the cumulative probability curve. The s-shaped curve (red) gives for every point the probability (on the right y-axis) for having an operating expenses less than the corresponding point on the x-axis. The shape of this curve and its range on the x-axis gives us the uncertainty in the forecasts.

A steep curve indicates little uncertainty and a flat curve indicates greater uncertainty. The curve is calculated from the uncertainties reported in the reporting package or templates.

Large uncertainties in the reported variables will contribute to the overall uncertainty in the EBITDA forecast and thus to a flatter curve and contrariwise. If the reported uncertainty in sales and prices has a marked downside and the costs a marked upside the resulting EBITDA distribution might very well have a portion on the negative side on the x-axis – that is, with some probability the EBITDA might end up negative.

In the figure below the lines give the expected EBITDA and the budget value. The expected EBIT can be found by drawing a horizontal line from the 0.5 (50%) point on the y-axis to the curve and a vertical line from this point on the curve to the x-axis. This point gives us the expected EBITDA value – the point where it is 50% probability of having a value of EBITDA below and 100%-50%=50% of having it above.

The second set of lines give the budget figure and the probability that it will end up lower than budget. In this case it is almost a 100% probability that it will be much lower than the management have expected.

This distributions location on the EBITDA axis (x-axis) and its shape gives a large amount of information of what we can expect of possible results and their probability.

The following figure that gives the EBIT distributions for a number of subsidiaries exemplifies this. One wills most probable never earn money (grey), three is cash cows (blue, green and brown) and the last (red) can earn a lot of money:

### Budget revisions and follow up

Normally – if something extraordinary does not happen – we would expect both the budget and the actual EBITDA to fall somewhere in the region of the expected value. We have however to expect some deviation both from budget and expected value due to the nature of the industry. Having in mind the possibility of unanticipated events or events “outside” the subsidiary’s budget responsibilities, but affecting the outcome this implies that:

- Having the actual result deviating from budget is not necessary a sign of bad budgeting.

- Having the result close to or on budget is not necessary a sign of good budgeting.

**However:**

- Large deviations between budget and actual result needs looking into – especially if the deviation to expected value also is large.

- Large deviation between budget and expected value can imply either that the limits are set “wrong” or that the budget EBITDA is not reflecting the downside risk or upside opportunity expressed by the limits.

Another way of looking at the distributions is by the probabilities of having the actual result below budget that is how far off line the budget ended up. In the graph below, country #1’s budget came out with a probability of 72% of having the actual result below budget. It turned out that the actual figure with only 36% probability would have been lower. The length of the bars thus indicates the budget discrepancies.

For country# 2 it is the other way around: the probability of having had a result lower than the final result is 88% while the budgeted figure had a 63% probability of having been too low. In this case the market was seriously misjudged.

In the following we have measured the deviation of the actual result both from the budget values and from the expected values. In the figures the left axis give the deviation from expected value and the bottom axis the deviation from budget value.

- If the deviation for a country falls in the upper right quadrant the deviation are positive for both budget and expected value – and the country is overachieving.
- If the deviation falls in the lower left quadrant the deviation are negative for both budget and expected value – and the country is underachieving.
- If the deviation falls in the upper left quadrant the deviation are negative for budget and positive for expected value – and the country is overachieving but has had a to high budget.

With a left skewed EBITDA distribution there should not be any observations in the lower right quadrant that will only happen when the distribution is skewed to the right – and then there will not be any observations in the upper left quadrant:

As the manager’s gets more experienced in assessing the uncertainty they face, we see that the budget figures are more in line with the expected values and that the interval’s given is shorter and better oriented.

If the budget is in line with expected value given the described uncertainty, the upside potential ratio should be approx. one. A high value should indicate a potential for higher EBITDA and vice versa. Using this measure we can numerically describe the managements budgeting behavior:

### Rolling budgets

If the model is set up to give rolling forecasts of the budget EBITDA as new and in this case monthly data, we will get successive forecast as in the figure below:

As data for new month are received, the curve is getting steeper since the uncertainty is reduced. From the squares on the lines indicating expected value we see that the value is moving slowly to the right and higher EBITDA values.

We can of course also use this for long term forecasting as in the figure below:

As should now be evident; the EBITDA Monte Carlo model have multiple fields of use and all of them will increases the managements possibilities of control and foresight giving ample opportunity for prudent planning for the future.

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