not create, and, in many cases, those top-down plans will not ref lect the line
manager â€™s knowledge of exactly what it will take to run his or her teamâ€”
erring on the low side could endanger client relationships and the quality of
work produced, while erring on the high side will result in unnecessarily
â€śBottoms upâ€ť budgeting is just the opposite of top-down budgeting. Line
managers prepare budgets that they believe they need in order to achieve
their objectives and then submit them to the finance department to consol-
idate. Without guidance from above, it is unlikely this first set of budgets
will aggregate to numbers any where close to the LRP requirement for the
firm. Once those initial drafts are submitted, it then may require an ex-
traordinary amount of work to tailor them back to a level that the firm can
372 The Back Office: Efficient Firm Operations
afford, wasting valuable management time in the process as well as creating
unnecessary ill will among stressed managers.
A practical solution for this situation is to take the best of both methods
by providing managers with order of magnitude target numbers for their de-
partment that are based on the parameters set forth in the LRP and then let
them develop their own detailed budgets using those targets as a guideline as
to where their final numbers should come in. Targets can be as simple as two
or three key numbers, including revenues from the clients for which they are
responsible, total compensation costs, and other out-of-pocket costs. Having
department heads or team leaders prepare their detailed budgets within
those targets can provide them with a sense that their input is valued by sen-
ior management and, in the end, the firm normally ends up with a more fea-
sible plan that will be supported by its key managers.
While setting targets, revenue should be broken down into its major com-
ponents, including a revenue plan by client, average billing rates for each
level of staff working on each client, total hours to be charged to each client,
and overall staff utilization rate targets by staff level. When finalizing rev-
enue targets, in general, it is better to develop realistic revenue estimates
that are achievable except for certain major catastrophic events and not
â€śpushâ€ť them in the target setting process. By doing so, the firm is more likely
to build its expense plan at a level that will be sustainable if relatively
conservative revenue estimates hold true. When revenue projections are
â€śpushedâ€ť to higher levels to motivate managers to improve overall perfor-
mance, expenses are likely to be planned at a higher level and the firm will
suffer if those more aggressive revenues fail to materialize.
In summary, a well-organized budgeting process will include many, if not
all, of the following steps:
â€˘ Establish the firmâ€™s objectives first in the LRP process.
â€˘ Quantify the annual budget for the firm as a whole based on the numbers
set forth in the LRPâ€”for both revenue and expenses. The LRP and
budget should be formatted in a way that maps exactly to the financial
statements of the firm to facilitate monthly reporting against the plan as
well as provide a consistent foundation for historical trend analysis.
â€˘ Break that budget down into departmental level targets that each man-
ager can use to develop his or her own detailed budget. While setting
those initial targets, be sure to allow sufficient funding at the â€ścorpo-
rateâ€ť level to cover overruns from individual departments that may be
necessary to finalize all budgets at the end of the process.
â€˘ Consolidate initial budget submissions from all departments to deter-
mine variances from original targets given as well as the overall plan for
the firm in total. Determine, at a high level, how much needs to be cut
from expenses (or added to revenue) to achieve LRP targets.
â€˘ CFO/senior financial management should conduct reviews of the first
draft of the detailed departmental budgets to understand key issues and
Finance, Accounting, and Human Resources
reasons they might not be able to live within the target they were given.
Finance then should provide department heads with specific guidance as
to how much needs to be cut and offer suggestions as to the source of such
changes (but be careful not to order certain cuts because that will under-
mine the main objective of this bottoms-up part of the overall process).
â€˘ Department heads will then revisit their plans and revise them if
â€˘ Department heads then make their budget presentation to the
CEO/CFO for their review of final plan. To the extent necessary, it is
at this point that the department head may negotiate resolutions to any
significant variances with the CEO to ensure overall strategic goals of
the firm are met.
â€˘ Once finalized with the CEOâ€™s approval, the CFO and CEO should
present the budget to the board of directors for final approval. Final
numbers then should be distributed to each responsible line manager to
ensure that they are fully aware of the final numbers to which they will
be held accountable. In an ideal world, all of the steps described would
be completed before the commencement of the new fiscal year. How-
ever, in practice it is not unusual for final approval to slip into the first
quarter of the new fiscal year. In those situations, it is important to en-
sure that line managers know how to operate while waiting for the
budget to be approved, particularly the procedures required to procure
MONTHLY FORECASTINGâ€”UPDATING THE ANNUAL BUDGET. Period-
ically, the annual budget should be updated to ref lect changes in the firmâ€™s
revenues and expenses that occur over timeâ€”both the actuals that have
been booked year to date and the outlook for the remaining months of the
year. Whether this occurs each month or each quarter is somewhat depend-
ent on the volatility of the business, its capital reserves, and managementâ€™s
preference. Updating the budget /forecast monthly, although arguably more
labor intensive, provides management with an economic outlook for the firm
based on the most current information available. Further, by incorporating
the forecasting process into the monthly managerial routine, it becomes
more efficient and less of a â€śbig projectâ€ť that tends to paralyze finance and
management staff when it is left to a quarterly update. For the remainder of
this section, we presume that the outlook for the firm is prepared on a
monthly basis and is referred to as the â€śforecast.â€ť
Development of the monthly forecast is much more of a bottoms-up ex-
ercise than is preparation of the annual budget because targets for the year
already have been established and the validity of the forecast is highly de-
pendent on line managementâ€™s current assessment of their capacity to
achieve their targets given actual performance year to date. When prepar-
ing the monthly forecast, consider the following:
374 The Back Office: Efficient Firm Operations
â€˘ Set up a spreadsheet in a financial statement format that shows all
major accounts listed in the same order shown in the firmâ€™s financial
statements going down the page, with a separate column for each
month going across the page. Array â€śactualsâ€ť for each month in the ap-
propriate columns and budget (the first time the forecast is prepared)
or the latest forecast for each line in the remaining months of the year.
Adjustments then will be made to each of the future months based on
the latest outlook for each account.
â€˘ Revenue forecasts must be made by client and must ref lect input from
each responsible client manager. When the compensation agreement
with a particular client is complex, a supporting spreadsheet should be
prepared and reviewed with the client manager. In some cases, particu-
larly those where client managers are loathe to take responsibility for
the forecast, it may be worthwhile for a senior financial person to sit
down with the manager, review the calculations and, in particular, the
underlying assumptions, and have the manager physically sign off that
the projections are his or her best estimate based on knowledge at that
point in time. Physical signatures, when managed properly, can dramat-
ically improve the accuracy of the firmâ€™s forecast.
â€˘ Expenses can be forecasted based on direct input from line managers as
well as a top-down analysis of the historical run rates for routine ex-
penses (e.g., electricity costs vary from $10,000 to $20,000 per month,
depending on the monthâ€”simply estimate future months based on his-
torical expenses by month, with a subjective adjustment to ref lect any
percentage increase in rates or expected usage). In addition to a high-
level review by account, financial managers may find it valuable to re-
view the spreadsheet of expenses by vendor for each account to adjust
for one-time anomalies past and future.
â€˘ Balance sheet and cash f low forecasts can be developed based on cer-
tain high-level assumptions. Most line items can be computed as a func-
tion of revenues or expenses, and the resulting impact on the firmâ€™s cash
f lows can thereby be estimated (e.g., A /R balance can be computed
based on assumption for days sales outstanding). A financial model that
integrates those assumptions into the workbook used to project the P&L
forecast should be used so that whenever one assumption changes, its
impact on all three financial statements will be computed automatically.
CAPITAL BUDGETING. The annual capital budget is a list of approved
capital projects and approved dollar amounts. A capital project may consist
of either a single item or a group of related purchases that have an expected
life in excess of one year and exceed the firmâ€™s minimum dollar value thresh-
old for capital treatment. For reporting purposes, capital is utilized when an
irrevocable commitment is madeâ€”not when cash is paid or an invoice is pre-
pared by a vendor or received by the firm.
Finance, Accounting, and Human Resources
In general, a capital budget for a given year covers that fiscal year only. For
most firms, there is no automatic carryover of unused budget appropriations.
If a project runs into a new fiscal year, the remaining spending requirement
should be separately approved as part of the new fiscal year â€™s budget.
When developing the capital budget, the same principles discussed earlier
for long-range planning and annual budgeting apply, that is, set macrolevel
targets within the context of the long-range plan and then have line man-
agers develop the detailed plan within those parameters from the bottom up.
In determining the actual level of capital spending for each department, the
following metrics may be helpful in rationing scarce capital resources:
â€˘ Capital spending as a percent of projected revenue
â€˘ Capital spending per projected headcount
Approval of capital project requests should be based on an analysis of the
projectâ€™s economic rate of return as measured by an assessment of its net
present value (NPV), internal rate of return (IRR), return on investment
(ROI), and payback period. Since most capital expenditures in a professional
services firm are related to information technology, many justifications for
replacement of basic personal computing equipment will not yield a mean-
ingful rate of return analysis. However, larger system development projects
should be scrutinized carefully to understand fully not only the initial capital
costs involved in developing the system, but also the ongoing operating and
maintenance costs related thereto (i.e., the total cost of ownership).
Once a capital project is completed, a postanalysis should be prepared on
all material projects to ensure assumptions that supported the original ap-
proval of the project in fact yielded benefits set forth in its economic justifi-
cation analysis. In practice, completion of this important analysis often falls
to the bottom of the priority list in favor of more urgent operational matters.
By not insisting on an accounting for each significant projectâ€™s actual returns,
management bypasses an excellent opportunity to learn from actual experi-
ence that may be applied productively to future capital request analyses.
Cost Estimates: Prebilling Authorizations to
Spend Your Clientâ€™s Money
Prebilling your clients based on an estimate of future expenses can dramati-
cally improve the firmâ€™s cash f lows. Doing so for profit on the interest earned
during the f loat period is not advised because it may significantly impair the
relationship with your client. Rather, such billing arrangements should be
utilized when the firm is asked to undertake projects for which significant
out-of-pocket expenses are required on the clientâ€™s behalf. In many cases,
the firm may need to move quickly on behalf of the client, often before the
client can physically forward the funds needed to cover the expenses. In
376 The Back Office: Efficient Firm Operations
these cases, the firm should establish and enforce a policy that requires writ-
ten authorization from the client that a certain dollar level of funding has
been approved for a specific purpose and that the client will pay that amount
before any commitments are made on the clientâ€™s behalf. If the firm fails to
secure that written approval from the client and the client subsequently
changes its mind about the project, the firm may be liable for all such ex-
penses. Thus, it is critical that these authorizations, also referred to as â€śesti-
mates,â€ť be signed before making any commitments. Finally, the firm should
ensure that its written agreement with its client include clear language as to
what types of expenses will be reimbursed to minimize any ambiguity that
may occur as the assignment unfolds.
Project Cost Accounting
One of the most important factors executive management can monitor and
control is the marginal cost of servicing its clients. The value of staff time
is the most critical variable factor in determining the total cost of a project
and thus must be rationed in accordance with expected revenues. In its sim-
plest form, cost accounting in a professional services environment compares
revenue from a client or project against the cost of providing labor, over-
head, and nonreimbursed out-of-pocket expenses to the client. Each of those
components is allocated as follows:
â€˘ Revenue: Revenues specifically related to the client and /or project are
separately identified in the accounting system.
â€˘ Direct labor: In general, direct labor costs ref lect the value of time
spent on the client or project. Direct labor costs are computed by tak-
ing the number of hours recorded on each personâ€™s timesheet for each
client and multiplying it by his or her per hour salary cost. In some
cases, the salary cost may include a factor to cover related benefit costs
as well. Further, some firms choose to use a standard hour factor other
than 2,080 (52 weeks x 40 hours per week) as the denominator for the
total number of hours in a year because not all of those hours will be
chargeable due to vacations, sick time, and administrative time. The ac-
tual denominator used is subject to management discretion based on ac-
tual experience and may fall as low as 1,500.
â€˘ Direct expenses: Direct expenses include all out-of-pocket expenses in-
curred by the firm in conjunction with the clientâ€™s assignment that are
not reimbursable by the client.
â€˘ Indirect labor overhead: Rarely is every hour of every employee in a
firm chargeable to clients. The value of the time not charged out
to clients is normally assigned to an indirect labor overhead account.
In simple form, it represents the salary cost of staff time spent on
Finance, Accounting, and Human Resources
administrative functions, including vacations and sick time. The total
cost to the firm may be allocated among all of the firmâ€™s clients for cost
accounting purposes in a number of different ways, the most popular of
which is as a percentage of total direct labor or revenue.
â€˘ Overhead: All other costs not listed in the preceding category are
grouped into an overhead category and are allocated among all the
firmâ€™s clients in a manner similar to that described for indirect labor.
Costs in this category include rent, taxes, insurance, office supplies, ad-
ministrative travel and entertainment costs, utilities, IT expenses, and
depreciation and amortization.
Once all costs have been allocated among the firmâ€™s clients and their re-
spective projects, management can then evaluate historical performance in
terms of each projectâ€™s relative profitability. Doing so for the past is helpful,
but using that information to evaluate and price future projects properly is
vital to the firmâ€™s long-term existence. When evaluating the results of a cost
accounting analysis, management must be conscious of the difference be-
tween marginal and fully loaded costs when determining if a project was
good for, or well managed by, the firm.
Projects that show a loss on a fully loaded basis (i.e., with all labor, direct,
and overhead costs included) may contribute positively to the firmâ€™s profit if
revenue exceeded the marginal costs of performing the work. In the long run,