Introduction to Budgeting and Cash Flow

What you’ll learn to do: Explain the purpose and logistics of budgeting and cash flow

The budgeting process helps retailers balance expenditures with incoming revenue.

As you have read previously, retailers manage a host of operational expenses like: rent, utilities, labor, and inventory costs. And, while the sale of products does provide income, the timing of the transactions means that retail managers may be awaiting revenue to pay off past purchases or to make new ones. Thus, there is a need to coordinate purchases and payments—cash flow. This can be especially complex, when considering start-up or seasonal businesses.

Cash flow refers to the total amount of money being transferred into or out of a business at a given moment of time. Businesses seek to generate long-term positive cash flow.

Budget Preparation

During budget preparation, the retail manager needs to ask and answer the following questions:

1. What are the expected sales for this time period?
2. How much merchandise on hand will be needed to produce the projected sales?
3. How much and when will price reductions need to be taken in order to dispose of merchandise to generate sales and revenue?
4. What additional merchandise purchases will be needed during the season?
5. What gross margin dollars and percent will be needed to achieve the desired profit?

On the face of it, these aren’t especially difficult questions to answer.

1. Perhaps we’d estimate that sales continue at the same rate that they did in the previous time period. Or, perhaps, we project that they’ll exceed last year’s (LY’s) sales levels by a certain percent (+x%). Or, it’s possible that we’d expect a given item to perform similarly to another.
2. If we have a fair understanding of expected sales (revenue) and the average selling price, we can easily determine inventory needs. Inventory = sales revenue / average selling price
3. This one is a bit more complex, but you’ll notice that in point #2, we didn’t divide sales revenue by retail price. Instead, we used “average selling price.” This conveys that we don’t expect to sell all items at full price. Rather, some portion of our inventory will be discounted to accelerate turns and reduce inventory (risk). Looking at past data, a retail manager may know what portion or percent of a product’s inventory will be discounted to ensure there isn’t remnant inventory. Further, they may have good information about when decisions to reduce prices should occur. Lacking appropriate historical references, a retail manager will have to monitor these decisions more closely.
4. This is a question of “What if?” What if we don’t have enough cash on-hand to order the full inventory need to meet our revenue goals? When will we need to re-order product? What if the product is far more successful than we expected and we’ll exceed our revenue goals? Will we be able to place more orders? Will they arrive in time to capitalize on the opportunity?
5. As you saw earlier, gross margin dollars and gross margin percent are easily calculated.
   1. Gross margin dollars = selling price – cost of goods
   2. Gross margin percent = (selling price – cost of goods) / selling price

Where this gets much, much more difficult is understanding “how much will be needed to achieve the desired profit?”

The challenge for a business is to build a budget that provides for the financial health of the company. That is, a budget that generates sufficient revenue to cover operating expenses, while also returning profit for reinvestment in the company or distribution to the owners in the form of cash payouts (dividends). Thus, the above questions take on heightened importance because they directly impact the financial health and future of the company.

If sales fall below budget projections, then there isn’t enough positive cash flow (income greater than expenses) to cover all operating costs or provide for reinvestment in the business. In this event, the firm risks several outcomes, such having to forgo important investments in the business that would spur future growth while its competitors move ahead or being forced to borrow funds to cover its performance miss, meaning that some future cash flow will be required to pay back the loan, including interest. It also may have to  reduce costs, possibly including labor or marketing, leaving people laid-off and promotions less effective than competition, respectively.

As you might assume, those are not good situations for the firm to find itself. Thus, the budgeting process becomes critically important to ensure the financial health and future of the company.

Zero-Based vs. Incremental Budgeting

Given the pressure to budget effectively, firms scrutinize the process. Ultimately, there are two common approaches for establishing an annual budget: zero-based and incremental.

Zero-based budgeting assumes that the budget is built from “zero.” That is, nothing is carried-over or assumed from previous periods. Often, there is a temptation within organizations to justify activity with “that’s what we’ve always done” or “last year, we did this.” Those justifications imply that past activity, and the associated spend, will be repeated. However, within a zero-based budget approach, past activity and spend should NOT be assumed. The budget is not based on previous budgets or past performance. Instead, each expense needs to be justified before it will be added to the official budget.

The benefit of a zero-based budget is that it forces decision-makers to scrutinize their assumptions about what has and will make their plan effective, prioritizing specific activities. For instance, consider a retailer that runs an annual back-to-school promotion, including granola bars, toaster pastries, and fruit snacks. Let’s assume that they invest $45,000 to advertise the sale, not including product discounts:

• Granola Bars
  • Sales revenue: $258,691.23
  • Gross margin: $ 63,638.04
  • Gross margin percent: 6%
• Toaster Pastries
  • Sales revenue: $103,724.51
  • Gross margin: $ 20,774.90
  • Gross margin percent: 0%
• Fruit Snacks
  • Sales revenue: $ 97,319.61
  • Gross margin: $ 32,115.47
  • Gross margin percent: 0%

Let’s assume this was a successful promotion—it did generate $116,528.41 in gross margin ($63,638.04 + $20,774.90 + $32,115.47), not including other items that shoppers may have added to their carts during the trip.

But, how might the investment change the next year, using a zero-based budget assumption? Think about the $45,000 advertising expense. Shouldn’t that be applied across each segment (granola bars, toaster pastries, and fruit snacks)? Do you start to feel differently about any of the product segments, knowing that $15,000 in advertising costs will need to be subtracted from their gross margin?

Said another way, would you still argue to invest $15,000 to advertise toaster pastries if you’ll only generate $20,774.90? As it stands, you have $5,774.90 ($20,774.90 – $15,000.00) to pay against other operating expenses, after allocating $15,000 in advertising costs. Would you be eager to defend that to your boss? With a zero-based budgeting approach, you’d need to defend the activity and spend, if you wanted to include it in the budget. That might be a tough task, indeed.

Incremental budgeting uses previous budgets and actual performance as a baseline from which to build forward-looking budgets. Each line item, meaning each planned expense, is adjusted to reflect expected competitive activity, economic factors, consumer trends, and other applicable issues that potentially affect performance. Thus, incremental budgeting takes into consideration the changing competitive landscape and the organization’s needs.

In this approach, decision-makers make adjustments to year over year (YOY) budgets, meaning compared to the last year, to reflect anticipated changes to the business environment. In the example used above, the manager might reflect the cost of advertising as $50,000, believing that media rates will increase in the coming year. Or, they may increase the expected sales revenue for each of the product segments, having seen positive trends for each throughout the year. These small changes are built into an overall budget that provides a comprehensive view of all activity and associated costs.

The benefit of incremental budgeting is that it challenges decision-makers to go in-depth to analyze planned activity and associated expenses. Further, it encourages those same managers to consider what trade-offs they’d make within their budget to prioritize certain activities over others. If leaders have determined that the total budget will not increase by more than 4% YOY, then a manager with an estimated budget of +7% will be expected to update their plan, prioritizing the plans that best assures they meet their annual goals, while reducing exposure on others to meet the +4% target. This is particularly effective when multiple decision-makers are competing for a limited supply of dollars to invest. Simply, leadership will challenge the managers to identify the best opportunities for growth, ultimately allocating funding for them while managing the budget to its target.

Ongoing Budgeting Process

For effective budgeting, the firm must first select its approach—zero-based or incremental. For zero-based budgeting, a manager needs a full list of expected revenue and expense items for the upcoming season. In this way, they can build their budget plan to show all the necessary information. That said, most retailers use incremental budgeting.

To facilitate the budgeting process, the retail manager needs to engage in an ongoing budget process. That means that the retail manager must closely monitor actual sales, cost of goods sold, and expenditures to see how closely actual performance aligns with the budget or plan that was originally created. Differences and their causes are noted so that decision-makers can make adjustments to operations. For instance, if an item is under-performing budget assumptions, the manager might promote the item, reduce its price, or seek to cancel future orders.

The company may use this same information about performance relative to budget to make adjustments at a more macro-level. Changes to the budget can be made across categories, division, or business units, allocating funds to certain areas while reducing funds for other areas. For example, if the cereal category is under-performing while the produce category is exceeding expectations, a retailer may reallocate funds from cereal to spur even greater growth in produce. Similarly, if a chain of stores operates several banners, funds may be shifted between those business units.

As you can see, budgeting is an ongoing process for a firm.  The job is not over when the budget is finalized. Instead, performance is continually monitored, relative to the budget. To ensure financial goals are attained, adjustments are made when necessary. Further, differences between the budget plan and actual results, and their causes, are taken into consideration for future budget preparation.

Seasonality and Cash Flow

Seasonality refers to an imbalance in the timing of sales revenue for a given class of merchandise. To simplify this, think about pumpkins and bulk candy, for example. Certainly, shoppers might buy pumpkins and bulk assorted candy throughout the year, but we might expect that these purchases peak in October, building towards Halloween. In this way, the market for pumpkins and bulk candy reflect seasonality. Yes, there are ongoing sales, but there are clear peaks in demand at specific times of the year.

Other examples might include winter holiday merchandise, which may sell beginning as early as Labor Day (early September) through late December, and swimwear, which may sell as early as January (beginning of cruise season) through early summer, with some retailers starting to markdown swimwear around mid July.

Of course, these are not exhaustive of all seasonal items, but are intended to give you examples. Within a supermarket, grocers might actively promote seasonal items and/or seasonal consumption of specific items. Think about heavy merchandising periods, including:

• January: Chips and soft drinks in advance of the Super Bowl
• February: Boxed chocolate for Valentine’s Day
• May: Flowers and greeting cards for graduates and Mother’s Day
• July: Hot dogs, ground beef, and buns for the 4th of July
• August: Back-to-school
• November: Turkeys and prepared pies for Thanksgiving
• December: Winter holidays like Christmas, Hanukah, or Kwanzaa

Cash flow refers to the total amount of money being transferred into or out of a business at a given moment of time. Businesses seek to generate long-term positive cash flow. But, because seasonality reflects an imbalance in the timing of sales revenue, cash flow can be uneven, creating challenges for how to manage the financials of the firm.

For example, consider Brighter Beach, a retailer that sells swimwear and accessories. As you would expect, their high selling season extends from March through August. Yet, the store is open year round, meaning the business incurs operating expenses, like rent, utilities, and labor, throughout the full year. Therefore, sales and profits during the summer months must be enough to cover all annual expenses. This includes capital to purchase goods (inventory) to sell in the coming selling season. It’s the timing of these transactions that makes budgeting decisions especially complex. The managers of Brighter Beach, and those at other seasonal businesses, may need to manage cash flow to pay off past purchases or to make new ones.