Contingency planning in business means preparing for the unexpected -- having strategies and action plans in place to deal with changes in the business environment that cause actual results to deviate from what had been budgeted. Planning -- also referred to as budgeting -- in business is not an exact science. Managers make assumptions about the future of their industry and the general economy that are educated guesses at best. One way of dealing with this uncertainty is to include contingency funds in the budget -- extra funds to deal with unforeseen events beyond what had originally been budgeted.
Benefits of Contingency Budgeting
Having contingency funds in the budget helps a company keep its operations running smoothly in the face of changes in the business environment that result in revenue shortfalls or higher than planned expenses. The management team has funds available to increase marketing expenditures to address an unexpected slump in product sales. If a project turns out to require higher than planned staff hours to complete, the company can keep the project going by tapping into the contingency funds to cover the unexpectedly high personnel costs.
Approaches to Contingency Budgeting
Some companies look at the expense categories that typically in the past have had the greatest variance to budget and increase the budgetary amounts to reflect the likelihood variances will occur in the upcoming year as well. Companies that spend a lot on fuel, for example, recognize that the cost of fuel can fluctuate depending on supply and demand factors in the oil markets. They include extra funds in this category to cover possible cost increases. Other companies simply allocate these extra budgetary funds to a general category such as “other” or “miscellaneous” because they aren’t sure which category is likely to experience a variance to budget.
Determining the Amount of Contingency Funds
Companies must approach contingency planning on an individual basis. No magic formula exists for calculating the correct amount of contingency funds to include in the annual budget. Early stage companies tend to have more dramatic variances to budget than more established businesses. Entrepreneurs often underestimate the cost and time it will take for their venture to reach positive cash flow. In the extreme case, a pure start-up venture may budget a contingency fund that is 10 to 15 percent or more of the total budget to make sure the business doesn’t run out of capital. Companies in industries experiencing slow but steady growth usually are better able to budget accurately than companies in rapidly growing, rapidly changing industries.
Problems with Contingency Funds
In the case of companies that assign budget preparation responsibility to each department’s manager, it’s important that these managers not use the philosophy of contingency planning as an excuse to pad their budget so they almost certainly will end up with positive variances. Managers may do this because performance reviews and resulting bonuses are often based on how their departments performed versus budget. The inclusion of contingency funds in a budget can also sometimes lead to sloppy budgeting, where managers don’t take the time to build logical revenue and expense models that are good predictors of what will happen in the upcoming year. They just plug a number into contingency funds and hope these funds are sufficient to cover any shortfalls that were caused by poor planning.