6 Keys to an Effective Budget

As we near the fourth quarter for calendar year businesses, most small and mid-size companies are starting to form plans for the new year. Many companies go so far as to have an actual budget, however too often those same budgets lose either their usefulness or worse still, provide a false sense of either panic or security.

Especially in the case of growing businesses, change is at the very core of many companies.  This means that last year’s assumptions may not work anymore.   Perhaps keeping gross margins flat and adding 5% to last year’s payroll costs is not a good representation of the upcoming year.  A solid budget must be a living document, not just something that sits in a drawer.  To do that, it must be measurable against actual performance, retaining the ability to meaningfully evaluate positives and negatives over time.  And in a good budget process, companies should constantly be asking an important question – why?

1) Revenue – Building Blocks

At its core, what really drives revenue in your business?  And based on that, what does that mean for the new year? What will happen to the price per unit of sales?  Volume sold? The number of customers – both existing and new?  So many financial items trickle down from revenue, a thoughtful, deliberate evaluation here is essential.

2) Infrastructure – What is Needed to Support the Revenue?

In order to drive the thoughtful revenue numbers above, what is needed from your people, equipment and other resources?  Do you have the capacity to reach the numbers needed?  This could mean more salespeople to generate new customers, more operations people to execute on the product, or another piece of machinery (and people to run it) to increase throughput.

3) One-Time Expenses and Purchases

It could be new software, a recruiting fee for a big hire, a new piece of equipment or legal costs, but large, infrequent expenses and purchases, and more importantly their effects, are often overlooked in budgets.  Where possible, the timing of these large outflows should be planned for to a large degree to ensure the business and its resources can absorb it.  Is simply taking the expected total and dividing its cost over 12 months an effective way to plan?  Possibly, but it can also result in negative consequences – it is likely best to plan for some lumpiness in the timing.

4) The Unseen Costs

As we have talked about the trickle down effects in the budget, it is easy to forget unseen costs in the business.  For any business with debt, new purchases, working capital needs and/or changing interest rates can all have an effect on the cost of capital for a business.  What about carrying costs?  If sitting on more inventory, what is the impact of that?  Maybe supplier or customer terms are changing – these can all have a sneaky impact on numbers moving forward.

5) Get the Team Involved

A sound budget process needs input from the key team members involved in executing it.  Even in small businesses, getting three or four people involved can ensure a thorough process with multiple viewpoints and evaluation from different perspectives. A solid budget needs input from the CEO, sales, operations, and finance.

6) Can You Justify it?

To properly utilize a sound budget, your team should be measured by it, you should be making decisions with and against it, and banks and other external stakeholders should be able to scrutinize it, with readily available answers.  A budget that is too aggressive will only lead to frustration, from both leadership and the team on the ground executing.  A budget that is too conservative could lower expectations and create lost opportunity.

An effective budget should be well thought out, all-encompassing and reasonable. And when it is so, the ability to truly measure against is an essential key to good management decision making.