Budgeting Process Best Practices

It is the time of year where budgets are a frequent discussion point. This year of course with all the uncertainty in the economy, many businesses are struggling with how to start or how to have faith in planning for the new year. However, with a good planning process, budgets can be developed with confidence in any season.

First and foremost, the key word is process. Too many companies establish budgets without an intentional process. This can lead to poor assumptions, confusing comparisons to actual results or a focus on the wrong numbers in the business. For small and midsize businesses, there is no one size fits all approach, so relying on best practices to help shape the best process for each business is a great approach. So, what exactly does that look like?

An often-overlooked area of the planning process is learning from the prior year. Not just where were numbers missed, but why? Was the assumption bad? Was there an execution miss, or was it a broader economic issue? The answer here is essential to plan forward. And a benefit out of the pandemic and economic disruption was that it created something of a laboratory learning environment for many businesses – exposing unseen weaknesses, providing a testing environment for new initiatives and strategies, and reassessing operating structures. There is a wealth of information to be relied upon in these current market conditions. Ultimately, there should be far more questions asked than answers provided, especially in the early stages of the process.

There are a number of approaches and styles to deriving numbers – top down, bottom up, and others. What matters most is that the budget is based off the drivers of the business. What really moves the needle? Is everything a trickle down function of revenue? Are the bulk of the costs above gross margin, meaning volume could be the key driver? What about customer mix or headcount? Do contracts, either customer or vendor, play a huge role? The drivers may not show up directly in the P&L. Many times, businesses are focused on areas that don’t ultimately drive the desired impact – for example, growing revenue without realizing it will require a lot more overhead, or spending disproportionate time on areas of spend that have little impact ultimately on the bottom line. A year like 2020 demonstrated the importance of understanding drivers as a business changes.

Understanding the impact of different scenarios is also critical. Using the drivers above, what happens if revenue is 10% higher or lower? What if it requires more marketing spend to generate the same dollar of revenue? After the set of initial questions in the process, the question of “what if…?” is one of the most powerful any business can ask. While briefly mentioned as an example above, a deeper look at mix can be very impactful. Certain customers can have a different margin profile. It often makes sense to look at the top 5 to 10 customers or segments of customers. How does a shift in volume affect overall margin and profitability? For many companies, this mix changed as a result of the pandemic. Look at mix – what if it stays consistent or reverts – what is the impact either way? Move numbers around, look at the impact. This will provide confidence in the bounds in which the business will operate. Very few businesses are going to nail their budget across the board next year but understanding the lanes of opportunity and impact is even more valuable long term.

We have always been advocates of 2 sets of numbers in many businesses. For example, a more conservative budget that expenses are planned off of, and a more aggressive top line and or margin forecast. With this approach, a business is far less likely to spend ahead of the revenue, ensuring increased rigor around profitability and cash, especially during times of uncertainty. Then as the conservative targets are met or exceeded, it affords the conversation around adding further spend, but in an intentional manner.

The budget process is by nature continuous and fluid. It does not stop once the plan is on paper. Budgets should be reviewed, at least quarterly, and at times monthly. What new learnings have developed? Given all the economic uncertainty heading into the new year, new plans may need to be developed as information is gathered over time. This does not mean the budget is thrown out the window by any means. It is still a crucial baseline with which to evaluate business performance, so revisions are more of an “and” than an “or”. Perhaps a large new customer emerges, perhaps a current one shrinks materially. Or perhaps there are positive or negative competitive pressures. These can warrant revisions to aid in decision making as the year goes on.

Now is a great time to re-examine the planning process in the business. Adding these best practices to the process can provide more clarity, confidence, and ability to respond to changes in the future. The seas will continue to be choppy. By plotting the course carefully and intentionally, a safe, successful journey can be made much more likely.