According to a survey by Clutch, 61% of small business owners did not create an annual operating budget. As the number of employees shrunk, the likelihood of a business creating an annual budget shrunk even more – 74% of businesses with 1-10 employees did not create a budget. Unsurprisingly, in another Clutch survey, 35% of small business owners listed unforeseen expenses as their top financial challenge.
An operating budget certainly doesn’t insulate you from unforeseen expenses, but it does force you to deliberately examine projected revenue and expense numbers for the upcoming financial period. The exercise, if done correctly, will make you prove, with real math, that your strategic and operational plans are going to deliver the financial results you desire.
Earlier in the One Year, Thirty Minute Challenge we looked at capital budgeting. Operating budgets differ radically from capital budgets. Capital budgets deal with large-ticket items that are depreciated over several years. Their purchase is not reflected in an operating budget. Operating budgets deal with income and expense projections for an upcoming fiscal period. Money that is typically both earned and spent in that period.
Operating budgets are based on assumptions – assumptions like “what we pay for utilities will stay the same”, “we will have no major customer defections”, “our health care premiums will go up 10%” and on and on. At the beginning of the budgeting period, you’ve got to validate every assumption as much as possible. It’s also prudent to document assumptions so everyone involved knows the “facts” the budget was built on. To illustrate, in 2020, you should assess and state your assumption about the effect of the coronavirus pandemic on your organization in 2021 – it will be a distant memory, we’ll be somewhat impacted, it will still be a major factor for us or somewhere across that spectrum.
Clearly, your 30-minute exercise this week isn’t long enough to pull together a budget, so the goal is to pull together a budget plan, get the plan to the right people and be able to clearly explain your budget methodology.
According to the Corporate Finance Institute, there are four methods for putting together an operating budget –
- Incremental – Start with last year’s actual revenue and expense numbers and ratchet them up or down based on a percentage or on anticipated changes in specific budget categories. I’m not a fan of this methodology, since it’s easy to perpetuate a budget that might have been built incorrectly in the beginning. And, it might be feeding budget categories that are no longer relevant to the success of the business.
- Activity-based – Begins with revenue targets then fleshes out the expenses needed to reach those revenue targets. This methodology works well for “cost of goods sold” expenses but might be a bit unruly when building the underlying administrative costs.
- Value proposition – Requires every expense to be tied back to some value creation activity for the customer, employee, shareholder, or other stakeholder. I like the premise here because, truly, if an activity doesn’t bring value, then why do it?
- Zero-based – Every single budget line begins at zero. From scratch, you must build every line item. Consequently, the existence of the line item and the amount must be justified. I like this one also, because of the discipline required and the scrutiny given to each entry.
You can choose one of these methodologies or a hybrid of two or three. The methodology takes a backseat to the real reason for doing a budget – to correctly fund value creation activities so that projected revenue goals are met or exceeded and expenses are right-sized so that all stakeholders receive returns that cement their relationship to the company. This incredibly important point deserves a bit more attention. Customer facing activities must be sufficiently funded so that purchasers receive a product or service that exceeds their expectations and is delivered in a way that makes them feel good about their purchase. Employee compensation must keep value producers inside the organization happy and engaged and not looking for employment elsewhere. Shareholders must receive a sufficient return so their investment in the organization continues to be justified. A similar calculation must be made for every stakeholder in the organization.
Let’s jump into a few mechanics for budget building.
- Involve the people ultimately accountable for hitting the numbers – The directors and managers who will reap the rewards or bear the consequences for financial performance for the budget entity (department, division, business unit) must create the budget for that entity. If they’re smart, they’ll involve other team members who will impact that entity’s performance.
- Simultaneously work bottom up and top down – Expectations for profitability should be communicated down and needs for funding value creation activities should be communicated up. The organization’s desired endgame should be baked into the company culture and should be a regularly discussed topic in the organization, so there shouldn’t be any surprises here. This is just an annual exercise dedicated to examining the financial manifestations of what you’re after every day.
- Use tools that make sense – A smaller organization might get away with an Excel template used by everyone in the organization. Larger organizations probably want to opt for some of the more robust budgeting tools available.
- Use the right level of detail – In your office supply category, you don’t need a line item for pencils, another for staples and another for paper clips. If you do, you have the wrong people in charge. Budgets reflect the level of autonomy in that business entity.
- Budgets should include contingencies, but those building the budgets should know that the ultimate determinant of investment is value creation – I’m in favor of adding some contingencies to a budget (for unforeseen circumstances – overtime, equipment failure, opportunity to capture an emergent opportunity), but ultimately, every expenditure in an organization should be about value creation. If a situation arises that affords an opportunity for value creation, even though that opportunity was not apparent at budget creation time, the person responsible for that budget entity should know that they can come to you with that opportunity and not be chastised for considering something “not in the budget.”
- Budgets function as a “reality check” for projected revenue and projected expense – Let’s say your budgeted revenue reflects the sale of 3 million widgets. What is the sales commission for 3 million widgets? What is the cost of raw materials for 3 million widgets? What is the labor cost for 3 million widgets (that requires that you know how long it takes to make each individual widget)? Will any overtime be required to produce 3 million widgets? Is the present capacity of your plant sufficient to produce 3 million widgets? What does it cost to ship 3 million widgets? Will the production of 3 million widgets force you to add another shift? What will be the cost of supervisors for that shift? Are all those items in your budget? The budgeting process is the mechanism that ensures you’ve accurately identified and synced all of the revenue and costs associated with the value creation activities that get you to your financial targets.
- At some point in the process, check your work against industry benchmarks – I’m not a big “best practices” person. Every “best practice” was once a wild idea gambled on by some innovative thinker. I’d prefer to put my money on the innovative thinker. However, that being said, it’s not a bad idea to check your work against your competitors – just to make sure you’re not missing something. For instance, you can easily find stats on what percent of revenue is spent on Information Technology in your industry. If your competitors are spending 4% of revenue on IT and you’re spending 2%, maybe you’re not being thrifty. Maybe you’re missing opportunities to automate work or offer new tech-enabled products.
- Bake in profit margins at the budget level – If you want to make a profit of 20%, make sure your revenue and expense projections enforce that margin. Engineer the value creation activities until you’ve pushed the revenue and expense numbers far enough apart to hit your profit target.
Get the responsible parties together and lay out your plan. If this is your first budget, it’s important to explain your rationale. It’s all about the discipline – the same reason you do a strategic plan or any other deliberate planning activity. It’s the opportunity to step away from the press of all the things that clamor for your attention and focus on, in this case, the finances of your organization.
After your budget is in place, check your performance against it regularly. Make it a part of your balanced scorecard. When opportunities come to deviate from it, use it as a development opportunity for your staff as you discuss the rationale behind decisions to “stick to it” or “stray from it”.