As we enter the final stretch of 2017, most business owners are focused on finishing the year well and maximizing their profitability. November is also the time of year to be preparing for the year ahead – which requires planning and budgeting. September’s Topic of the Month dealt with Strategic Planning. This month’s topic will cover the budgeting process. The budget typically starts with the income statement – projecting revenues, expenses and net income. Since “cash is king” in most businesses, it is also important to budget cash flow for the upcoming year through a full financial budget.
This Topic of the Month will address the annual budget – purpose, budgeting methods, recommended process, and the use of budgets in decision making.
Purpose of the Budget
A budget is a useful planning tool which enables a business to meet its goals for the year. The budget provides a financial picture of the business and its operations for the coming year. However, a budget is only effective if it:
- Contains well-defined goals which align with the long-term strategic plan,
- Is based on sound assumptions and accurate financial information,
- Has appropriate input from the key members of the management team,
- Provides direction to implement operational changes required to meet the plan,
- Incorporates actions needed to address SWOT issues – e.g., risks and opportunities,
- Is communicated throughout the company at the relevant levels,
- Contains documented assumptions explaining the rationale behind the numbers, and
- Is prepared on a timely basis and monitored regularly throughout the year.
Budgeting allows business owners to set objectives, notice trends, anticipate peak periods, incorporate marketing efforts, measure progress and monitor the health of the business. A budget helps a business plan how to use its limited resources to accomplish it goals and ensure that the company has sufficient cash flow to meet its obligations.
Various approaches to budgeting have been developed to address different issues within a company. All approaches work, but some are easier to apply.
Bottom Up Approach
The bottom up approach to budget development begins with management at the department or unit level preparing draft budgets that comply with general guidelines provided by the executive management team. Draft budgets are then reviewed with executive management. The company-wide budget is a compilation of the separate department or unit budgets, with necessary adjustments made by executive management.
The most effective bottom up approach to budget development is zero-based budgeting. The premise behind this method is that no costs should be automatically included in the budget simply because such costs occurred in the past. It starts every year with a clean slate and forces the explanation of every dollar that will be spent. It is designed to minimize budget buildup of expenses that can occur over time, especially in larger organizations.
Zero based budgeting may be too time-consuming, costly or complex for some small businesses. However, the underlying principles of zero-based budgeting are worthy of consideration for all businesses.
Top Down Approach
The top down approach to budget development usually starts with the executive management team setting company-wide revenue and expense targets as well as targets for the individual departments or units. The executive management team generally produces the first draft of the budget and then sends it to the department or unit managers for review.
The top down approach is often necessary for efficient budget preparation for small private companies. However, careful attention should be given to the underlying assumptions used in the preparation of the budget. If a budget is created simply based on historical numbers and the view of a few people, you may be building last year’s mistakes into this year’s budget.
Recommended Budget Process
Since the top down approach to budgeting is most often adopted by small private companies with limited time and resources to devote to the annual budgeting process, the following discussion will focus on this approach.
Generally speaking, while an optimistic best case scenario and a more conservative worst case scenario are important in preparing a budget, using the best estimate of “most likely” outcomes for revenue and expenses results in a budget that includes a realistic assessment of the financial impact of future operations. It is important that consideration of cash needs under each scenario is documented and communicated in the budget process so that any potential liquidity problems can be mitigated.
1. Revenue: Set 2018 revenue targets and review 2017 month by month.
- Set the 2018 revenue target in reference to the revenue targets in the company’s three year strategic plan.
- To build in seasonality:
- Review 2017 (prior year) monthly revenues and adjust for known issues.
- Allocate the total 2018 revenue target to months based on your 2017 adjusted revenues.
Example: If 2018 revenue target is $2 million up from $1.5 million in 2017, that represents a 33% increase. If July 2017 had revenues of $250,000 then the budget for the same month in 2018 should be $300,000. If July 2017 was only $100,000 gross revenues, then 2018 adjusted would be $133,000 for the same month.
- Align revenue targets to your revenue-generating strategy.
- Determine the likely sources of 2018 revenue. Review your existing customer base for key products or services that might generate higher revenues in 2018. Consider adding new products or services, price increases to existing customers, and/or adding new customers to generate higher revenues. Revisit the company’s SWOT analysis to determine areas of potential opportunity to increase revenue, and consider potential revenue threats to mitigate.
- Evaluate your potential revenue gap – i.e., the difference between 2017 revenues and the 2018 revenue target. It will give a sense of the achievable revenue. Budgets should have some level of “stretch” (target revenue > known achievable revenue), but should be realistic.
- Develop three realistic strategies to fill this revenue gap.
- Be sure to consider the seasonality of your business as you prepare your budget.
2. Expenses: Evaluate expenses line-by-line to determine which will increase as revenues grow.
- Review the impact on margins to determine how cost of goods sold will grow as the revenues increase. This may lead to consideration of whether to outsource a portion of operations (or certain functions) versus having it done in-house.
- Consider whether any additional resources (costs) will be necessary when revenues increase – e.g., additional marketing or administrative support, expanded facilities, etc.
- Review compensation to ensure that it is not growing faster than inflation (2.2%).
- If compensation is growing, examine the reasons for the growth – e.g., increased number of staff, increased employee benefits or other costs, overtime – and determine the impact on operations.
- Test for expense growth given revenue growth using a percent of revenue. Example: If 2018 projected revenue growth is 25%, be sure that expenses are not growing in any area by more than 25%, including compensation. If percentage is higher, this may be a potential problem area that needs further investigation.
- Examine the top three expense line items and determine ways in which those costs can be more efficiently managed.
3. Net Income: Review net income as a percentage of sales.
Determine if you are satisfied with your Return on Sales and the efficiency levels of your company. Many clients ask what the appropriate amount of net income should be. While there is no fixed answer, the following approach may be helpful in determining how to set an appropriate net income target. Since the business or company is an “investment” to the owner(s), a return on investment (ROI) analysis is worthy of consideration.
- ROI = net income ÷ amount invested.
- Net income for this purpose is after market-level compensation to all workers including owner management.
- Amount invested can be calculated based on:
1) Book value of equity
2) Value of assets less liabilities
3) Value of business (not usually the better choice since it is circular)
- Note: Net income is pre-tax.
- The return should reflect the risks in the investment.
- Example: (Book value) $3 million by (target return) 10% = (Targeted Net Income) $300,000
- Target returns for 2018 are:
- Risk free – US Treasury 10 year Notes are 2.3%
- Public companies expect 8-12%
- Private companies are generally higher than public ROI.
- Many companies may find “net income” using an ROI approach to be quite high. This may highlight the need to:
- Better manage the business using ROI thinking.
- Review the compensation to owner. The level of compensation may be high, effectively including what would otherwise be ROI.
- Consider the industry in which the company operates and the appropriate level of ROI for the industry.
- Evaluate whether the business will have low or no returns during start-up or due to other factors.
4. Budgeting Cash Flow
Most budgets are built at the income statement level. To understand the cash needs for the business throughout the year, it is important to model month-by-month balance sheets and cash flow statements to prepare a full financial budget.
A monthly full financial budget will show the growth in working capital as the seasonality of the business is modeled. The growth in working capital generally requires cash or other liquidity, such as lines of credit, to fund the inventory and accounts receivable during the busy seasons. Using only an income statement does not allow for this aspect of good budgeting to be seen. A full financial budget will automatically have the cash flow requirements shown on the cash flow statement. This allows company management to anticipate the months that will have cash flow needs and provide time to find the best option to meet those needs.
Budget Review and Monitoring
The budget should be monitored on a regular basis throughout the year and compared to the actual financial results achieved. Monthly reviews by the executive management team are necessary to manage financial and operational performance. Likewise, department heads should receive monthly reports on actual versus budgeted amounts for their area of specific responsibility. It is important that these reports are accurate and timely, to assist management in making appropriate decisions and taking corrective action to address revenue shortfalls and expense overruns as and when needed. Further, in order for management to take effective action, it is important that any deviations or variances of actual financial results versus budget be analyzed and explained.
Remember the budget is a planning tool to assist management in achieving the desired goals for the year. It is a dynamic document, a financial plan for the future. Since future events do not always unfold as planned, the budget should be reviewed regularly and modified or updated as market conditions change.
Tutorials & Articles for Further Reading:
- Building a Financial Budget. This article provides practical tips for the budget process. (http://www.entrepreneur.com/money/moneymanagement/financialanalysis/article21942.html)
- Q&A: Seeing Beyond the Annual Budget. This article describes the “big company” issues in budgeting. (http://www.inc.com/articles/2003/09/qahope.html)