This article provides an overview of the essential concepts of business budgeting, and discusses the key principles necessary for doing it effectively. Learn how to develop a budget that can help you plan and manage your financial resources and achieve greater success.
Business Budgeting: Knowing the Foundations of Effective Financial Management
Why Do I Need a Business Budget?
There are four key reasons why budgeting is important, even critical, for any business looking to get ahead. Firstly, budgeting links strategy and finance together. As business owners, we tend to spend quite a lot of time thinking about and planning our strategy. However, strategy cannot happen in a vacuum. We must incorporate a planning loop that connects our strategic plan with our financial plan, this then drives our tactical plan. Without pulling all these elements together then we’ve only got half a plan, which isn’t a plan at all. A budget quantifies the strategy by providing the necessary numbers for future planning and proactive decision-making.
Secondly, budgeting enables us to learn from history. History tends to repeat itself, particularly bad history. By going through the budgeting process, we can understand what worked and what didn’t in the previous year. We can then challenge the status quo and make improvements. Budgeting is an evolving process that helps us learn from history and continually enhance our approach.
Thirdly, budgeting promotes alignment within the organisation. Finance serves as the common language of business. The budget process and its outputs enable us to align departments and managers around the financial goals for the year. So rather than just flying around aimlessly, we’ve got the landing lights on, and we’ve got an airport to fly to.
Lastly, the budgeting process allows us to get a better understanding of the fundamental drivers within the business. It allows us to delve into the core profit model and gain a better understanding of how our business operates. This understanding then informs the cash flow forecast, which is crucial for financial planning. The budgeting process itself provides substantial value. You get as much value out of the process itself as you do out of the actual financial plan.
What Does a Bad Budget Look Like?
Before we get into what makes a good budget, it’s probably worthwhile looking at what makes for a bad budget:
Just a sales forecast
While sales forecasting is important, it only provides a partial view of the entire financial picture.
Last year + 10%
This discounts any chance for improvement and adjustment in the business model. We can’t just assume that past performance is sufficient for future success.
Optimistic and unachievable
A budget should strike a balance between aspirational goals and practicality to encourage meaningful progress and drive performance.
Only involves owners/management
It should be communicated effectively to all relevant parties, highlighting its significance in driving the business forward and achieving shared goals.
Lives in the bottom drawer
It should not be treated as an afterthought or simply stored away in a drawer, forgotten for months on end. A budget should be a living document that undergoes regular review and updates as circumstances change.
The 7 Fundamentals of a Good Budget
Learn from History
We’ve already touched on this, but it is such a crucial point. While we are not solely governed by historical data, it serves as the best indicator of what is likely to occur in the future. We should not simply add a fixed percentage to last year’s figures; instead, we must delve deeper into understanding why certain outcomes occurred and learn from them.
By analysing what worked and what didn’t work in the previous year, we can identify the factors that contributed to success or failure. This includes examining the assumptions we made in our previous budgets and evaluating their accuracy. We take this opportunity to learn from any incorrect assumptions and adjust our future plans accordingly.
The budgeting process is not a one-time event but an evolutionary one. Each year, as we engage in budgeting, we strive to improve and refine our approach. By incorporating lessons from the past, we enhance our decision-making and forecasting capabilities.
Link with Strategy
When we set our strategy at the beginning of the year, outlining our target markets, customers, and desired product lines, it is crucial that the budget aligns with these strategic objectives.
The budget serves as the implementation tool for our strategic plan. It is where our strategic decisions materialise and where we can assess the feasibility and financial implications of our chosen course of action. For instance, if we have decided to expand into a new geographical area or introduce a new product line, the budget should reflect the necessary resources and investments required to support these strategic initiatives.
A critical aspect of this linkage is the allocation of financial resources to strategic investments. Whether it involves investing in talent, infrastructure, equipment, or other elements impacting the profit and loss statement (P&L), these investments need to align with the strategic direction of the business. By ensuring that the budget supports these strategic investments, we integrate the financial and strategic aspects into a consolidated business plan.
Realistic, not optimistic
The budget should not be treated as a fairy tale, if it’s too optimistic and not grounded in reality it will inevitably be put in the too-hard basket and disregarded. So we need to base it on the most likely scenario for the business.
Where this really comes into play is in the revenue forecast. This should be a manageable top-line sales target. Typically, stretch targets are set for the sales team to encourage high performance. However, if the budget is based solely on the best-case scenario, it can quickly become irrelevant and outdated if actual performance falls short. Setting unrealistic targets from the outset puts the business at a disadvantage, leading to frustration and a loss of confidence in the budgeting process.
Don’t build your budget off a best-case scenario, base it on what is most likely to occur, not on what we want to occur.
Have a revenue model
Building a revenue model goes beyond setting sales targets and is more about understanding the factors that contribute to revenue generation. Firstly we need to focus on our invoiced sales or recognised revenue and not our sales orders. Then we need to determine the costs associated with this revenue. To do that we need to have a clear understanding of our product mix, the types of customers we’re targeting, supplier relationships, and all the factors that impact costs associated with different products and revenue streams.
It comes down to getting a really good understanding of the relationship between our revenue and our gross profit. By having a revenue model in place we gain a clear understanding of these relationships, and we can accurately forecast gross margin and ensure that it aligns with the revenue projections.
Examining and saving money is a crucial fundamental of budgeting. It involves reviewing and challenging expenses to ensure that the business is not overspending or wasting resources. While it’s not about indiscriminately cutting expenses, it’s important to identify areas where savings can be made without compromising the business’s ability to achieve its targets.
Start with the revenue model and see which expenses are essential to achieving your targets. And rather than using last year’s budget as a starting point, build your expenses from a zero base. This ensures we aren’t throwing good money after bad in maintaining expenditures that we’re not getting value out of.
One common area to review is subscriptions. Over time, these small recurring expenses can accumulate and become a significant monthly cost. By reassessing the value and necessity of each subscription, businesses can eliminate unnecessary ones.
Savings should not be limited to overhead expenses. It’s crucial to also evaluate costs above the line, such as cost of goods sold or direct costs. This may involve negotiating with suppliers, seeking efficiency gains, or exploring alternative suppliers. Additionally, analysing the ratio of costs above the line compared to below the line can reveal opportunities for improvement.
The sixth fundamental of budgeting is being funded. It involves assessing whether the business has the necessary financial resources to support its budgeted plans and activities. This is particularly important for cash-strapped businesses and extremely important for those looking for substantial growth.
We need to have a good look at what the capital requirements are for the year ahead. Can we fund these from the profits of the business or do we need to potentially look at external funding? There’s no point in setting large growth targets if we can’t fund them.
The final fundamental of a good budget is to keep it alive. Creating a budget is not a one-time activity; it should be an ongoing process that involves monitoring and reviewing actual performance against the budgeted targets.
To keep the budget alive, it should be integrated into the business’s accounting system. This allows for regular reporting of actual performance compared to the budgeted figures. Whether these reports are for internal use or external stakeholders, they provide valuable insights into the business’s financial performance.
Analysing the variations between actual and budgeted figures helps identify areas of overperformance or underperformance. By understanding the reasons behind these variations, the business can make informed decisions to capitalise on positive trends or address any areas of poor performance before it becomes a bigger problem. This ongoing analysis allows for proactive management and adjustments to ensure the business stays on track towards its financial goals.
For business owners, budgeting serves as a valuable tool for decision-making and scaling up management. Instead of reviewing detailed profit and loss statements line by line each month, you can focus on the three most significant variances between actual and budgeted figures and get the big picture.
Choosing the Right Budget Template
Choosing the perfect budget template for your business is an important task. A good budget template will simplify handling income and expenses, empowering you to make well-informed decisions about the impact of projected and actual costs on your company’s profitability.
Customisable budget templates, like those offered by Google Sheets and Smartsheets, allow you to tailor your budget to your specific business needs.
The Business Budget Template for Multiple Products, which is available on Excel, enables you to track single or multiple-project budgets, providing a comprehensive view of your company’s financials.
Another option is the Startup Budget Template, which offers a single-sheet calculator that gives a complete overview of your business expenses. This template provides a quick insight into your projected average monthly costs based on your budgeted and actual income and expenses. It allows you to compare projected and actual expenses and also comprises of a first-year budget calculation section.
Pre-made budget templates, such as the Intuit free budget template, and Gusto budget template for startups, are designed to help you track costs, estimate initial revenues, and identify cost-saving opportunities.
In Excel you can find the Business Expense Budget Template, which includes a planned expense’s sheet that outlines projected employee, office, marketing, training, and travel costs, and compares these against a sheet of actual expenses. This template also features an expense analysis sheet that provides a dashboard view of your organisation’s overall financial health, allowing you to assess the discrepancy between projected and actual expenses.