Oil & Gas Monitor https://www.oilgasmonitor.com/budgeting-101-oil-gas-industry/6068/
A traditional budget is a repetitious dance between upper management and the Board, meant to determine certain targets. Typically, the CFO or accounting head kicks off the budget process in October (or the beginning of the final quarter of the fiscal year), and budget templates are distributed in Excel format. Last year’s results are incorporated in the template, with the numbers grossed up, usually due to inflation. Sales are forecasted. High targets are set to satisfy the Board. For public companies, quarterly projections and analyst expectations are considered. After a few budget draft reviews, presto, you have a budget. Once approved, it is usually filed away and not looked at until that first quarter meeting, or in many cases not looked at until close to year end.
Sound familiar? This traditional process, while typical for most organizations, is doomed to fail. Why? Here’s what you can expect:
- The budget targets set are often unattainable because the budget was a top down approach influenced by the Board and upper management, not a bottom up approach that takes sales and operations into consideration.
- Last year’s expenses were used as a basis for establishing the expense side of the budget. If you had an error in expenses or unnecessary expenses, you’re just building in your first mistake.
- The budget is often looked at as that “project” the finance and accounting teams do every year. The CFO and finance staff are in charge and issue instructions. Instead, the budget should be looked at as the tool that sets the goals for the entire company. Various levels of the employee base and management must be involved. The CFO should be the cheerleader of the budget, and share ownership of it with multiple stakeholders.
- There is not buy-in from the rank and file. Often, the mid-level and lower level management team members are not in agreement with the approved budget, and there is no ownership of the budget throughout the organization. This leads to a cultural problem and accountability issue.
Developing a budget is more than just a spreadsheet where predictable numbers are plugged in and signed off on by the CFO. In today’s environment of sophisticated ERP systems, quick financial closes of the month end numbers and a changing economic environment, the budget must be a flexible and agile tool that gives management insight into the business. It’s a business guarantee: things that you plan will change. Life changes, economic conditions change, management changes, political events change, so why not have a budget that can adapt?
The oil and gas market is an industry that is subject to strong and violent changes. No one can predict what oil or gas prices will be in 12 months, but we can be pretty sure they will change. The changes in oil and gas prices have a direct effect on all budgets related to our industry.
More than any other industry, oil and gas companies must have an agile budget and accurate rolling forecasts. With the amount of timely information that flows up to the financial statements every month, there is no reason why an oil and gas company should not keep track of a rolling forecast. The rolling forecast, preferably an 18-month rolling forecast, should be updated as soon as the month-end actual results are available. Companies today are expected to react quickly to a changing environment, which means decision makers cannot wait until the end of the quarter or the year to see where they are relative to the annual budget. The rolling forecast and the annual budget should go hand in hand.
Usually when there is an annual budget in place, everyone is aiming for the sales targets, but the problem with the traditional annual budget is that if there are approved expenditures everyone will spend right up to the authorized amount. There is little thought or incentive during the year to control spending and come in lower than the approved expenditures.
In the book The Nuts and Bolts of Budgeting, Ron Rael identified 4 critical elements of budgeting. They are:
- The Overall System: This is your budgeting process. Does your system produce cooperation, communication, honest and realistic budgets that allow people to make decisions?
- The Mechanics: Make realistic assumptions and build realistic models. This means detailing relationships among revenues and expenses, performing “what if” calculations and inputting the most realistic figures into the final product.
- The Environment: The environment is your culture, and your culture has a huge impact on your budget. Leadership actions and attitudes should support a realistic budget, and the Culture must incorporate accountability, controllability, communications, continuous improvement, empowerment, training and trust.
- The Mechanism for Change: This is probably the most overlooked element of a flawed budget process. Budgeting is no longer just a one-time annual event. Budgeting has become a 365 day per year management process. The budget must be designed with agility in mind.
Other important points in regards to budgeting, especially in the oil and gas industry, are to consider all four budgets. We live in a capital intensive industry so the following budgets are necessary:
- The profit and loss budget
- The balance sheet budget
- The capital budget
- The cash flow budget
Most companies focus on the profit and loss with some emphasis on the capital budget, but the balance sheet and cash flow are virtually ignored. Capital is king in oil and gas, so the cash flow budgets and balance sheet budgets should be carefully monitored to ensure the funds to invest, manage operations and be prepared for emergencies are readily available.
Lastly, but perhaps most importantly, effective two-way communication, between management and team members can determine the success or failure of the budgeting process. Most companies claim they are good communicators but that’s not necessarily true. Margins, profits and bad news are often not shared with the lower ranks because companies, especially closely held companies, don’t want employees to know all of the details.
Lack of communication, particularly in a crisis, is the most damaging factor to the culture of your firm. A clear line of frequent communication generates trust between your employees and management. Where would your firm be without your employees? A company supported by quality employees who trust management can weather any storm. Communicating your budget and actual results as they occur is a good way to start that communication process.
It’s never too late to shake up the budget process and redesign it so that it’s a business tool instead of a project. Businesses that use multiple types of budgets and incorporate them into the corporate culture in a meaningful way are better prepared for success in the long run.