TIS- Dealing with Uncertainty in Budgeting March 2010
The future is uncertain, and there will always be elements of uncertainty that are built
into projected financial statements. It is also advisable to ensure that decision makers
are aware of these elements of uncertainty when presenting them with financial
projections. There are a number of approaches to this issue including:
Sensitivity Analysis
Expected Values
Simulation
Rolling Budgets
Sensitivity Analysis
Sensitivity Analysis entails carrying out calculations with one set of values and then
substituting other possible values for the variables to see how the affects the outcome.
In the case of budgeting this involves revising the assumptions made in the budget
and calculating a revised budget. It may entail the use of worst case and best case
assumptions.
Illustration
A public service plans to deliver 500 units of a service.
Fixed costs are estimated to be £20,000 with some certainty, but unit variable cost are
expected to be £40 with a best case scenario of £30 and worst case of £50 .
Produce projected budgets based on all three assumptions:
Answer
Variable costs
Fixed Costs
Worst Case £
25,000
20,000
Expected Case £
20,000
20,000
Best Case £
15,000
20,000
Total Cost
45,000
40,000
35,000
In practice there may be a large number of complex assumptions in a budget, and
computer spreadsheets make the alteration of various assumptions much easier.
However the spreadsheet needs to be well designed, so that a single alteration in
assumptions enables the whole budget to be changed. A large number of spreadsheets
can be linked, but since consolidation can be complex , mistakes can be made .
Expected Values
An expected value is the forecast of the each outcome multiplied by the probability of
achieving that outcome to form a weighted average( with the probabilities being used
as the weighting).
Expected Value = Sum of ( Each outcome x its probability)
n.b. The sum of the probabilities must be 1
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Expected values can be used where probabilities are assigned to various outcomes
and a worst/most likely /best possible analysis is conducted. This is illustrated below
by building upon the example used in the previous section on Sensitivity Analysis.
Illustration
A public service plans to deliver 500 units of a service.
Fixed costs are estimated to be £20,000 with some certainty, but unit variable cost are
expected to be £40 ( probability 0.50) with a best case scenario of £30 (probability
0.20 and worst case of £50( probability 0.3)
Calculate the expected value of the costs:
Answer
Best Case £
Variable costs
Fixed Costs
Worst Case £ Expected Case
£
25,000
20,000
20,000
20,000
Total Cost
Probability
Probability x Cost
45,000
0.3
13,500
35,000
0.2
7,000
40,000
0.5
20,000
Expected
Value
15,000
20,000
38,500
Simulation
This method assumes that all variables associated with a budget are susceptible to
change, and assigns probabilities to each variable in turn. Then using random numbers
and a computer, multiple possible scenarios are generated.
Rolling Budgets
A rolling budget is one that is continuously updated by adding a further accounting
period (month or quarter) when the earliest accounting period has expired. Rolling
Budgets are therefore useful in dealing with volatile situations where is it is difficult
to produce a detailed budget for the whole year.
In some organisations this may entail the annual budget being divided into two parts:
1) A short period e.g. 3 months for which detailed budgets are prepared for
control purposes
2) The balance of the budgets for the year are in outline only.
3) At the end of the control period, the whole of the budget is reviewed and a
new control budget set for the next short period and a new outline budget for
the whole of the next year is created. This must tie up with overall
organisation targets and strategies
The use of Rolling Budgets means that managers always have a full years budget
available and the rolling process forces them to continuously think ahead.
Rolling budgets are used quite widely in the private sector. However they are less
widely used in the public sector, due to the need to get political approval of detailed
budgets on an annual basis.
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