The Budgeting Process
A good budget provides the business with a financial plan that establishes business parameters, an operational plan that dictates the resource requirements, and a marketing plan that sets goals for sales.
A good budget co-ordinates the various parts of the business; helps communicate the goals and objectives of the business to budget holders; motivates all levels, owners, managers and staff, to achieve the organisational objectives; helps control the activities of the business; and provides a tool to help evaluate actual performance against the predetermined set of goals.
A good budget will allow for sensitivity analysis on key drivers of the business, such as changes in sales volume, changes in gross margin percentage, movements in interest rates and movements in foreign exchange rates for importers/exporters. Having the flexibility to run sensitivity analysis allows management to understand the financial impact on the business if certain events happen in isolation or simultaneously.
So where do you start with a budget? The best place to start is with the strategic plan and the business plan. Many small businesses will not have a formalised strategic or business plan but will have an idea of what they want their business to achieve. Thought should be given to the long term objectives of the organisation, not just focusing on the year ahead.
The budget should incorporate the Key Performance Indicators (KPI’s) that are used to monitor actual results to reveal how well the business is forecast to perform against predetermined levels. Indicators such as gross profit margin, Stock Turnover, Days of Debtors, Return on Investment, Debt to Equity ratio can be used to evaluate the business performance.
The budget should encompass both external and internal influences on the business. External influences include the economic environment, labour force, legislation, international trade agreements, technology, customers, competitors, and suppliers etc. Internal influences include products and services, pricing plans, marketing, staff, and resource availability. Once these issues have been addressed the information gathering and budget writing process can begin.
So how do you write a budget? There are various ways in which you can approach a budget, the most common methods are historical and zero based or modified zero based. The historical method is the most traditional method of budgeting. Results achieved from previous years are used as the basis for the current year budget. Adjustments are made on individual lines of income and expenditure if there are significant expected departures from the previous year. The advantages of this method are that it is simple and comparatively quick to produce compared to other methods. The down side is that innovation and initiative can be stifled and overspending rewarded with the same budget as previous years.
The Zero Based Budgeting (ZBB) method starts each year from scratch and each line of income and expenditure needs to be justified. Typically ZBB is based on unit output. Income and Expenditure are built up from a unit produced basis. The advantage of the ZBB method is that each year you question the validity of income and expenditure lines and delve into what drives each line rather than accepting what happened last year. The down side of ZBB is the amount of time required to prepare the budget.
The choice of method will generally be dictated by the business in question. For example, the historical method would best suit a long established business that does not change much from year to year. The historical method may not suit a business that is dynamic and constantly evolving, in this instance ZBB maybe a more appropriate method.
Once a methodology has been selected the budget can be developed. The resulting income and expenditure figures then flow through into a cash flow forecast. For a number of businesses this is the area that generates the most anxiety. Even the most profitable of business can have cash flow problems. New businesses, businesses experiencing rapid growth and businesses with irregular income streams in particular need to forecast and monitor cashflow requirements.
The benefit of knowing when a cash flow shortfall will take place is that it can be managed properly by having lending facilities in place. Whether it be a temporary facility with the bank to cover a short term cash shortage or a long term lending facility to cover a more permanent cash shortfall will need to be determined. Lending institutions will be more receptive to financing requests if a budget is presented showing when cash flow shortfalls are forecasted to occur and how much the shortfall is, rather than presenting historical figures and a hunch.
A number of businesses operate permanently in overdraft robbing the business of essential working capital that the business needs to grow. Being able to forecast this occurrence and having the ability to fix the hard core of that overdraft into a longer term facility will free up working capital as well as saving short term finance costs.
Understanding the working capital cycle is important when forecasting the cash flow of an organisation. The timing of money from when goods are procured, to the payment of those goods, to selling those goods, to payment being received for those goods is important to understanding the cash needs of the business.
Once the budget is complete it is essential that it doesn’t find its way into the bottom draw, or worse the rubbish bin. Monitoring actual performance against the budget is an essential management tool so if there are any variances from the budget they can be analysed and remedial action taken if necessary.
The actual results can be measured back against the forecast KPI’s to track the performance of the organisation. Reporting actual figures against the budget also allows better cash flow management as cash shortfalls may not have eventuated or, conversely, they may have blown out – either scenario of which affects the forecasted funding requirements. Monitoring performance regularly ensures potential funding problems can be mitigated in advance.
Budgeting is an essential tool for businesses of all sizes. If the process is handled correctly and there is ownership from all concerned a budget can assist not only in monitoring the business but also the growth of a business.
DISCLAIMER No liability is assumed by Baker Tilly Staples Rodway for any losses suffered by any person relying directly or indirectly upon any article within this document. It is recommended that you consult your advisor before acting on this information.