This article is based entirely on the real-world experience of working with privately owned businesses. It’s not theory; it’s all about what works and the very severe risks of not engaging a proper budgeting process.
* Written by Alan Rodway from Your Coach Online
Some of the reasons given by businesses for not engaging a (proper) budgeting process are:
- “The business is too small (to bother)”. A small business is as important to its owner(s) and people as any larger business, so all proper business management processes should be used to maximise its outcomes. The risks of a small business not budgeting properly are as great as they are for larger businesses. Not budgeting adds to the possibility of just meandering and ‘working harder’ to achieve results.
- “Don’t have the expertise”. If the financial and planning expertise is not present within the business, then there are ways to cost effectively source it from outside, e.g. the business’s Accountant (although some accountants will either be inept at this, won’t have time or are too expensive … they should be changed if any of these are the case) or another professional.
- “Don’t have time”. To claim this is to not understand the power of budgeting and what it does for any business.
- “Our industry is different; it’s too hard to estimate future numbers”. All industries are different. If very large corporations can budget down to the last dollar, irrespective of their industry, estimating things like fuel usage (and therefore kilometres and price of fuel), cost of supplies, energy costs, etc. then so can any business.
- “It’s just a guess, so what’s the point”. It’s more than guesswork; it’s thoughtful planning.
(If you believe you have an effective budgeting process, you may still pick up some ideas to improve your current approach from this article).
It’s so important to stress that it’s not about having a document called a budget; it’s about the budgeting process that causes financial, behavioural, planning and decision making disciplines, including:
- The planning discussions and decisions that are required, leading into the year (see “The Line by Line discussions” segment below);
- Keeping expenditure items throughout the year within the numbers that were agreed upon at the outset.
- Achieving revenue numbers throughout the year that was agreed upon at the outset.
- The involvement of (key) people in the process … to help plan, make decisions, uphold the required accountabilities and to get their behavioural buy in. (But a one-person business should still be engaging a budgeting process).
- The importance of having clear objectives and targets so that there are behavioural impacts to achieve them.
- Directional and strategic discussions that result from the objectives that are set.
Budgeting should cover both Profit & Loss (‘P & L’) and Cashflow. Managing profitability and cash flow, whilst related, are not the same. Businesses can be profitable and still be cash poor. This article will concentrate on P & L budgeting and a subsequent article will address Cashflow budgeting.
How to create a P & L budget:
It takes at least two months to create and agree on a full P & L Budget for the coming year. There must be input from as many people in the business as possible, to get buy-in as well as more accurate numbers. It takes this long to have the required discussions, engage the appropriate thinking and do any research that’s necessary. Remember it’s not the document that’s so important, it’s the processes behind it, and people involved in creating it also have their ‘normal’ work to do.
The budget must be ‘signed off’ by the middle of the month before the financial year starts, otherwise, it’s not a budget. Too many businesses sign off on their budgets after the financial year has started … that’s just a tad contradictory.
Accurate historical data on all revenues and expenses and their timings must be at hand to make forecasting easier and practical. This can take quite some time to set up, especially if budgeting is new to the business.
The budget must be set down on a month by month basis (not just annual totals), seasonalised (not just with each line item divided by twelve months), properly categorized within revenue streams (if there are various segments within the business) and properly categorized within the expense items (with appropriately grouped expense items, not every individual item listed … that would make it way too long and with less meaning).
An initial draft P & L Budget should be created and then adjusted through discussion and further input until the final budget is reached. This requires meetings along the way to achieve that. So, there may be drafts 1, 2, etc. before agreeing on the final budget.
Everyone involved in the business should sign off on the final budget numbers that relate to their area within the business, to get their buy-in behaviourally.
A warning for businesses that have never (properly) budgeted, their historical financial data may be difficult to source or may even be inaccurate. Whilst that’s less than ideal, making a start on budgeting is the commencement of remedying that. It can take a year or more to create an effective budgeting and reporting process. That’s better than not ever getting there. And a comment about Accounting software packages … most of them do not have a capability to create a P & L budget as is being advocated in this article. (ABBS Note: MYOB fortunately does)
The line by line discussions:
Below are some examples of line by line discussions which illustrate the power of the budgeting process. These discussions would be had with the appropriate people (responsible for the items), both in groups as well as individually.
- Are each of the revenue items achievable?
- Do they represent adequate increases on the past year?
- Are appropriate marketing and sales strategies in place to achieve them?
- Have all sales and marketing people signed off on the revenues?
- Has competitor activity been considered in setting the numbers?
- Are the numbers properly seasonalised (i.e. allocated across months according to when they are actually recorded)?
- Are there opportunities for government grants?
- Can the discounts offered to customers be reduced?
- What are the threats to the revenue numbers and what’s in place to overcome them if they occur?
- Are stock levels being managed to optimal levels?
- What can be done with older stock?
- How can stock turns be increased?
- How can margins be better managed?
- How can stock losses be reduced?
- Is the advertising and marketing spend allocated to the most effective media, given today’s swing to digital marketing?
- Are we engaging adequate modern day marketing expertise within this spend?
- Will the fee to external accountants give us the financial expertise we need for the year?
- Should the fee be negotiated to a retainer rather than hourly rate?
- Is the I.T. spend the most appropriate and effective in today’s world?
- Has cloud technology been considered?
- Should the I.T. personnel capability be in-house or outsourced?
- Does the wages expense take into account all remuneration increases, bonuses payable and new people who will start during the year?
- Will the staffing levels be able to generate the revenues?
- Does each month have the correct number of pay periods represented?
- Is the total staffing cost at an appropriate percentage of total revenue? (Many businesses benchmark this at around one-third, but it’s also impacted by the industry and other factors).
- Are owners’ salaries and other forms of remuneration accurately represented within the budget?
- Have all known or likely price increases been factored into expenses?
- Are the insurance premiums the most cost effective that can be achieved (without compromising the cover)?
- Is business debt structured and sourced in the best possible ways, giving the most cost effective interest expense?
- Is there a possible upside in converting principal and interest loans to interest only (if that’s possible) or vice versa?
- Is the debt to equity ratio for the business optimal?
- Can the taxation expense be reduced (in future years) by improved tax planning? Or through validly changing any aspect within the P & L budget (e.g. Research & Development, depreciation, immediate write-offs, expense v capitalisation of expenditure)?
- Are motor vehicle expenses cost effective re how the vehicles are used, fuelled, housed, financed, serviced and maintained, and replaced?
- Is the rent/lease expense the best that can be negotiated?
- Should leases themselves be reviewed?
- Are the premises themselves appropriate for the longer term?
- Is the staff training and development expense likely to drive productivity up? What aspects of this should be conducted internally and which sourced from external providers?
- Is the total travel expense necessary (compared to video link ups, for example)?
- What has it achieved for the business in the past?
- Will the entertainment expense help to generate the revenues the business expects?
The point of the questions above is to demonstrate how creating a month by month, line by line, seasonalised budget can force discussions, planning and therefore decisions that will increase the profitability of the business. There are many other lines by line discussion aspects that could be had; the list of not meant to be complete.
A question is often asked, “Should budgets ever be changed?” Only under extreme circumstances. For the rest, it’s strongly recommended to keep the original budget in place to enforce the necessary disciplines behind the whole process. To overcome a situation whereby a budget is being significantly over or underachieved and the risk of it becoming less relevant to discussions, use a Forecast column in the P & L Report to take care of variances to date. The Forecast column combines actual months to date with the remaining budgeted months to give a more realistic targeted year end figure.
It is (obviously) a necessary part of effective budgeting that monthly reporting is in place, whereby a P & L report is produced showing actual figures for the past month and year to date, against budget and against the same period last year. That gives the comparisons to two of the benchmarks we want … what was expected and last year. (It’s a separate point to then make comparisons against others in the industry). ABBS can provide a P & L reporting template in soft copy. Just email firstname.lastname@example.org if you would like it sent to you.
The question is sometimes raised whether a rolling twelve-month budget is more effective than a yearly budget. This really is more about the circumstances of the business, it’s structure and reporting requirements than anything. It’s a whole other question that some businesses should be examining.
A very strong point has to be made about businesses that set stretch or high budgets, on the basis that if they don’t achieve them it sets the bar high and achieves a better overall result. The only way those budgets should be set is if a realistic yet challenging budget is also in place, i.e. that there are two budgets in place. Chasing a stretch budget, year after year, sometimes or often not achieving it, can lead to less than accountable behaviours.
It’s never too late in the year to create a budgeting process. Whilst it’s less than ideal, it’s better to start immediately than to wait. Budgeting for the remaining part of the financial year is still useful and gives a head start to the following full year.
It’s also powerful to link the budgeting and reporting process to the production of key metrics for the business and this topic will be addressed in the next article.
So, why have a fully fledged budgeting process?
Because profit will increase!
If this all seems overwhelming, you probably need help. Get it now or contact us via email@example.com This is too important to let go for any reason.
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