In one of my recent blog posts, I mentioned the need for a business to create an annual budget.
One of my readers contacted me, saying “I don’t really know why I’d need a budget if I’m already doing the basic bookkeeping”. So, in this post, I’m going to set out why I think budgets are so important for every business owner, whatever the size of your venture.
Feedback for improved decision making
However complex or simple your business model may be, you still need to be constantly monitoring progress and adapting your processes as you go. I come from an engineering background, and in that world we often talk about an ‘engineering feedback loop’, where outputs of a system are monitored and used to help the system operators decide how to respond and adapt to what is going on in the system.
It’s not just engineers who exploit feedback. Pyschologists use an approach called Test-Operate-Test-Exit (TOTE), which is a process to apply the same approach to people. With the first Test of the TOTE, we consider what’s happening and make a plan. Then we move on to execute the plan – Operate. After operating, we Test again to get some data or information on what happened. Was the outcome what we expected, or did something different happen? In the final step, Exit, we use the data to decide whether to continue what we’re doing or whether to make changes, possibly even terminate the exercise.
Your annual budget should be understood as part of a feedback loop for your business plan. We start off by creating a plan, which we express in financial terms as a budget. Then we operate the business, getting feedback from our management accounts. We use that feedback to make decisions – whether to continue as is, or to make some changes. So we are going about improving our understanding of performance and feeding that into our management – in short, we’re tracking how well you’re performing against that all-important budget, and then acting if change is needed.
Prompting a review of the business
In the normal running of a business, it’s very easy to get caught up on the treadmill and not take time out for important reviews. But there’s real value in making the time to focus on your budget and to make proactive use of it.
To prepare a budget, you must start with some key assumptions. These include:
- What will we be trying to achieve in the budget period?
- What will be happening with our key inputs – raw materials, labour, overhead, distribution etc?
Your budget provides, indeed prompts, a forum for these key discussions about the direction of the business. And the budget process forces you and your management team to formalise those discussions, reducing them to a set of guidelines that will be used in developing the budget to make it work comprehensively for your company.
Helping to anticipate what might happen.
In the western films that I watched when I was younger, the wagon trail or cattle drive would send someone ahead to scout out the land coming up, identify obstacles and find the best path to be followed, while the main train or drive remained behind – in other words, they never put the whole wagon train at risk, only the poor scout who’d pulled put the short straw!
We can’t really do that in a business – running a business comes with inherent risks that impact on the whole ‘wagon train’. But what we can do is to build a model of what we think is going to happen and use that to identify obstacles and make plans for how to deal with those obstacles.
For example, when we prepare a budget, comprising profit and loss, balance sheet and cash-flows for a business with peak sales at Christmas, we might see that it’s necessary to build up a substantial stock in the run-up to Christmas. This means we’ll need to buy raw materials from our suppliers to build this stock up, but we won’t have sold the product yet and won’t have received the sales proceeds. So we’ll be spending, without recouping any revenue and that’s going to put pressure on our cash flow.
By planning a sensible budget we can quantify the scale of the problem and plan how to address it. We might ask the suppliers for extra credit or we might ask our bank for an extra short-term credit facility – anything that eases the pressure of that increased outlay.
But unless we run some numbers, we wouldn’t be able to quantify the issue – we’d be basing any decisions on estimates and guesses, and that’s never good practise.
Developing our understanding of the business
To prepare a budget, we start by making some assumptions about what will happen in the business and how the different elements of a business relate to each other.
Depending on our experience and our knowledge of the business, the quality of assumptions can range from very poor to excellent. The only way we know how good these assumptions are is by comparing what actually happened with the budgets and studying the outcomes so that we improve our understanding.
By doing this on an ongoing basis:
- We gradually increase our understanding of what is happening.
- We improve our ability to predict.
- We also learn to identify key predictors of performance.
- We use these key predictors to make early interventions if things are not progressing as we expected – and keep the ‘wagon train’ on a safe passage through the pass.
Using our budget, we can also determine some key metrics for the business. For example, we should always know the break-even point for the business – the point at which our gross profit will match our overhead costs.
If the business is still in its early stage, the budgets can help determine just how viable that business is.
Budgets vs forecasting
Budgets and forecasts are very similar. They’re both financial projections of what’s expected to happen in the business in the future, with the aim of helping you move forward as effectively and profitably as possible.
Budgets are usually annual while forecasts can be run as often as needed. Well-run businesses will prepare an annual budget and then prepare less detailed forecasts during the year. These forecasts will usually incorporate changes that are occurring in the business and help management decide how best to respond to these changes.
Additionally, budgets are often used to set spending limits. In larger companies, the budgets are broken down by departments or cost/profit centres and individual managers are allocated responsibility for their portion of the budget. Usually, they won’t be allowed to spend in excess of a budget without first getting additional approvals from more senior managers – in other words, they place a restriction on the costs that department can incurr.
In smaller companies, the control process won’t be as formal. Usually, an owner manager will hold the purse strings tightly. However, the budget can be used to help them decide on how much they can spend on different types of expenses and, also, if there are better times than others for spending. Once the busines owner know what their limits are, they’ll soon realise if spending is exceeding the pre-defined plan.
Getting product costing right
An area that many businesses struggle with is product costing – working out the amount it costs your business to produce each product or service in your range.
Some businesses use product costs to set selling prices. Even when prices are set by the marketplace, using product costs to understand profitability will help you determine if it makes sense to be trying to sell in the market place.
Most product costs have two fairly distinct components:
- Direct costs – these are usually the easiest to determine and will include things like labour and raw materials etc.
- Overhead costs – these can be more difficult, and can include things like building rent, repairs to equipment or utility bills etc.
To determine overhead costs, the first thing we must do is determine the total amount of overhead costs we expect to have – that will be provided by the budget. Then we should figure out the best way of allocating the overhead costs to the products – effectively spreading the overhead costs across our products so that each product gets a fair share of the overall costs.
While all elements of the costing process are important, we must start with a reliable estimate of what the overhead will be and that’s provided by the budget.
The foundation on which your business plan is built
So, there you have it – a number of strong reasons why every business, both small and large, should take the time every year to build a budget and to spend some time comparing actuals with budgets.
Your budget is the financial foundation on which the whole of your annual business plan is built, so the more detailed, the more accurate and the more realistic you make it, the more solid your financial progress and agility will be over the course of the year.
If you’ve got any questions about building a solid 2017 budget for your business, please do get in touch to see how we can help.