Many assume budgeting is something that everyone should do, like brushing your teeth or showering. Let’s take a step back and look at the benefits of budgeting that have led to its importance. Knowing the benefits helps us better capture them.
Mapping Out Strategy
The budget flows out of your strategic planning. That planning process goes from conceptual and strategic to tactical implementation. You will identify which strategies and tactics you will implement over the next year in your budget.
You may find that the strategy is extremely difficult to attain. A CEO once whispered in my ear at a board retreat, “Do we have enough capital to do what they want to do?” To answer that, a budget would tell me the amount of cash we produce from operations and how much financing we would need. A budget can help a business anticipate and plan for potential financial challenges. This can reduce the risk of financial difficulties in the future.
You may run forecasts throughout the year. The budget is usually when significant new assumptions and strategies are projected. Updated assumptions come from your business environment assessments (e.g., SWOT analysis). Updated strategies, priorities, and goals lead to new forecasts.
The budget still acts as a map once it’s approved and we enter the budgeted year. Budget-to-actual reporting checks to see if we are staying on course. Our vision of where we are heading rarely changes, but our path there often does. As our path changes, we update our forecasts or may even create a new budget.
Achieving our goals takes time and money. These scarce resources must be invested in those activities that provide the highest returns. Budgeting forces prioritization.
The accrual- and income-based budget leads to a cash flow projection. That projection may show that we need to take steps toward getting a loan or equity infusions. If we project strong cash flow, we can then make plans for investing or distributing it.
Cash flow projections should be made throughout the year. The cash flow projection derived from the budget is usually the year’s most accurate cash flow projection. The budget projection often completely replaces data in whatever system (e.g., spreadsheets or planning software) you use to make periodic projections. Later projects are then layered in modifications as the year progresses.
The budget process is inherently iterative. I’ve seen budgets with version numbers in the 20s. It can be maddeningly iterative due to the gamesmanship in the process.
Sales targets lead to investment needs (e.g., salaries, advertising, and locations). Multiple rounds of adjustments of revenue and expenses are needed to find a mix to reach profit targets.
So why do I list this as a benefit of budgeting? Budgets force hard choices. Compromises must be reached within the tensions between goals. The struggle can spark creativity. It’s not easy, but the process can be very productive.
Key Performance Indicator (KPI) Targets
The KPI development process can be broken into two stages:
- Picking metrics
- Picking targets for those metrics
Picking metrics defines the indicators of success. Setting targets defines the metrics levels needed to be successful. Many of those targets come from the budget.
Those targets may be assumptions in the budget (e.g., number of repeat customers, units sold, utilization rates). They may be outputs calculated in the budget (e.g., sales dollars, gross profit, net income, return on equity).
Once the budget is approved, you have also set the targets for many items on your KPI dashboard.
The budget may also set compensation targets. This would include profit share bonuses, sales bonuses, and other incentive compensation.
Related to all this is the budget as a motivator. People are driven to achieve goals. The targets set by the budget encourage the performance needed to achieve those goals.
Your budget records assumptions and their financial outcomes for the next year. Larger companies often prepare a “budget packet” with many pages of commentary about the business and its environment. This packet goes well beyond the projected financial statements for the next year.
The budget captures many aspects of what the company will do in the near term to achieve its larger strategic plan. The budget is only one part of this, though. I would prefer to call the “budget packet” something like a “one-year plan” in which the budget is an important part of that plan.
The budgeting process can also increase the flow of information up through the company to top leadership. This is especially true in “bottom-up budgeting,” which I’ll discuss later.
The approved final budget is sent to managers and employees to let them know expectations and authorizations. Budget approval often unleashes a torrent of purchases and hiring.
The budget may be sent to lenders. It’s often sent to owners. Owners may use budgeted owner distributions for their personal financial planning. I was the CFO of two community banks. The only question that consistently came up in our annual shareholder meetings was, “What will the dividends be?”
Sensitivity and Scenario Analysis
The one thing I would promise when I presented a budget is that this is not what is going to happen. I wasn’t saying the budget is completely wrong. I was saying there are too many unknowns. The future is uncertain.
Scenario analysis lets us see a spectrum of outcomes. You can run scenarios based on the budget but adjusted for negative or positive variances. Stress testing is a specific form of this. You identify a possible extremely negative outcome and your plan to mitigate it. A highly positive outcome allows you to identify potential uses for excess cash.
Sensitivity analysis helps us identify the key assumptions of the budget. Potential changes in some assumptions may cause massive changes in profit or cash flow outcomes. This allows managers to focus on those key assumptions in daily operations and strategic planning.
Break-even analysis is another type of scenario analysis that’s very common with startup companies. It’s a good exercise for any company trying to reach profitability, or that might potentially drop below profitability.
The budget is often the only time assumptions and financial outcomes are well-developed and documented. Business strategy is like a series of experiments. You’re testing a series of hypotheses. One example is minimum viable product (MVP) testing. Others include:
- Will increased advertising lead to more sales?
- Will a new location lead to better customer satisfaction and more sales?
- Can we grow sales to a higher level without costs also increasing?
Budget-to-actual reporting and other budget variance analyses are filled with information about the relationship between actions and outcomes. Budget variances can be valuable learning experiences.
Benefits You May Have Thought I Was Going to List but Didn’t
Two commonly listed budgeting benefits are investment profitability and expense management. They are good things to do, but their emphasis during budgeting should be reduced. Budget season is a very busy time. It’s best to shift as much analysis as possible to other parts of the year to smooth out the workload.
Investment and Project Profitability
Analyzing new investments and projects is very time-consuming. Do that analysis during a slower time of the year if possible. Then, you can focus on the following during budgeting:
- Decide how many projects and which projects you have the capacity for in the next year.
- Update the forecasts for the projects recently implemented or budgeted to be implemented soon.
- Layer the updated forecasts into the budget.
An example occurred when I worked for a large credit union that wanted to remodel all existing branches and add new ones. This totaled over 20 branches over five years. The remodels and builds were prioritized mainly based on profitability. Each year, we decided how many branches we had the capacity to remodel and build. I made more accurate forecasts based on our recent builds and remodels.
Once again, expense management should be constantly ongoing. The budget is a plan to implement strategic cost savings, some of which were identified in earlier analysis. Other expense savings will likely be identified during the budgeting process. However, doing thorough expense analysis during the budgeting process makes a busy time even busier.
Better Budgeting Leads to Better Performance
Knowing the benefits helps us better capture them. Capturing these benefits can improve your company’s performance. Do you want to improve your company’s budgeting process? Check out my Better Budgeting course.
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