Building a Budget – Why You Should Have One and How it will help you!

It’s the season of planning for entrepreneurs and managers and building a budget is perhaps the most crucial. But there are many companies shying away from building a formal budget for the year. Is this a healthy practice for any business or is budgeting a worthwhile endeavor? Find out more here...

The new financial year is upon us and for anyone who owns or manages a business, this typically means you’re knee-deep in “planning season.”  Tax planning, cash flow planning, heck even holiday planning…the list goes on.  For many businesses, this also means budgeting out projected performance for 2020.  I see many small and mid-size companies sometimes shy away from building a formal budget for the year.  The most common reasons or excuses are, no one has the time, no one knows how, I’m allergic to Excel, or we’re growing so fast that a budget would probably be obsolete in 3 months anyway!  Now while the latter of those examples is rare and awesome problem to have, I’m here to tell you why in any scenario, even in hyper-growth environments, a budget is a very worthwhile endeavor and one you should prioritize it if you already haven’t.

Top 5 Reasons to Build a Budget :

01. One word : Accountability

As Ferris Bueller once said, life moves pretty fast.  Especially in smaller growth environments, things can tend to change on a weekly (even daily) basis. Without a formal framework or structure around the operations of a business, things can start to slip through the cracks quickly.  A budget serves the same function as an operations framework.  It allows a business to hold the sales team accountable to the sales targets they agreed to, a recruiting team accountable to the hiring targets they thought were reasonable, etc. for every functional area of the business.  If necessity is the mother of invention, accountability is the mother of progress for a small business, and a clear budget and direction for an organization helps put that vision on paper for all to be cognizant of and buy-in to.

02. Provides visibility into key business drivers

I see this dynamic happen all too often:  a business starts the year underperforming, the leadership team comes to the table and mutually agrees to cut costs, someone asks the open-ended question “what costs can we easily cut today?”, and no one has an easy answer.  It’s at those exact moments I wish there was a physical manifestation of a budget in the form of a superhero that could swoop in and say, “Budget to the rescue!”  I picture the budget superhero looking so mething like a combination of George Clooney from Up in the Air combined with Chris O’Donnell’s Robin suit from Batm an & Robin.  Ben Affleck would be the natural choice to bring the role to life since he’s capable of playing both Batman & some guy named ‘The Accountant’ – mild spoiler, he’s more than just an Accountant. 

But I digress, a budget is the perfect way to isolate not only what is driving current business performance, but where are areas to cut costs.  One thing I’ve seen work well is to highlight areas of spend that can easily be shed on a budget’s dashboard.  That makes it very easy to articulate what costs can be cut if sales targets aren’t being hit.  Some common examples of ‘low hanging fruit’ budget items are marketing initiatives, additional travel, team events, or additional hires budgeted for the year.  If you have a well-oiled budget machine, it’s very easy to remove these variables to see what the potential cost savings look likes for the remainder of the year as adjustments need to be made.

03. Allows for more accurate forecasting throughout the year

One of the more common excuses I hear for not building a budget is that a leadership team acknowledges they know it’ll be completely wrong in 6 months.  Even in scenarios where projections are very ambiguous and subject to change rapidly, I highly recommend a budgeting exercise.  Allow me to explain why and if you take anything away, I hope it is this:

A Budget doesn’t have to be correct to be an effective tool and drive strategic decision making. I put that in bold to make it easier for you to go back and reread because it’s that important.  I had a great and somewhat crazy finance professor in college who used to say that “forecast” is a Latin word for “wrong.”  Some nice managerial finance humor for you there, but I think you get the gist (if you don’t, reread this paragraph).

It doesn’t need to be perfect, just needs to be a reflection of what you think is most likely to happen.  Some of the best strategic decisions and discussions happen because a budget variance is discovered.  The physical act of benchmarking actual performance for a given month v/s a budget is an extremely helpful exercise because you’ll immediately know:

• Did the business over/underperform relative to expectations? More importantly…. why?  More sales? Fewer expenses? a combination of both?  Was it a one-time variance or will it continue?
• If we spent less money, where did we save those dollars? Is that money we can now deploy elsewhere?
• If we incurred more costs, is that a recurring spend that we need to add to the remaining months in our budget?
• Based on YTD performance, what is our most likely forecast of annual performance for the year?

All these questions are easily answered with a consistent budget tool.  I’ll give a graphical example below from one of our trainings we routinely do on the topic of budgeting.  Below is a very consolidated sample of a budget v/s actual view for a fake company’s financials for a given month:

Pretend you are sitting on the board of this organization and giving that analysis a quick scan.  Think for a minute on what questions you would ask the company’s CEO in a board setting before reading ahead…

If you’re like me, then some of the questions you might ask are:

• How did we sell more but incur fewer COGS?  That’s an interesting dynamic that warrants further investigation.
• What drove the 10% variance on admin comp?  Were certain positions or bonuses eliminated?
• This was a very financially healthy month, does that project to continue?
• Our Overhead/Other budget was on point! We should give our finance team all a raise!

Those are all very strategic questions (ok – except for the last one) that can be gleaned simply by looking at a budget vs actual view.  Again, if you take anything away from this, I hope it’s the exponential benefits of benchmarking actual performance against a budget based on buy-in from the entire leadership team of your organization.

One other subtle nuance that graph calls out that I wanted to highlight is the importance of looking at budget variances on both a $ and % basis.  The reason that’s so necessary is some budget line items are going to be larger $ values than others.  A payroll variance of $10,000 may only be 1.5% off from the total payroll budget, whereas a variance of $5,000 on travel costs for a month may represent a 40+% swing.  I’m much more inclined to investigate the narrative behind that 40% swing in travel spend vs the 1.5% swing in payroll costs even though the payroll amount represents a larger $ amount .Not all budget variances are created equal, which is why the visibility into both the $ and % is necessary.

04. Adds credibility to finance discussions about the organization

Having a formal budget that is reviewed regularly adds credibility to the overall level of finance-related conversations that are held both at the leadership level and throughout the organization.  If done well, things like revenue and net margin targets are very healthy goals to share organization-wide and can be rallying targets for the team. 

Obligatory word of caution:  if you’ve never shared financial information with your entire team before, do so very incrementally and intentionally.  It can create an entirely new subset of personnel issues if net margin targets are shared with no context i.e. – employees unaware why an organization is comfortable taking a loss in certain months based on seasonality or investment in long-term growth or unaware why a healthy net margin doesn’t mean a bigger bonus for them at the end of the year.  Good or bad, always contextualize the narrative of the financial plan, especially for less finance savvy folks.

By integrating YTD performance with budgeted numbers through the remainder of the year, a leadership team can maintain a consistent pulse on the projected annual performance for the year – and also how that performance stacks up against prior years.  This also allows for MUCH more fluid conversations with any potential investors or lending institutions if they ask to see a forecast or projection of annual performance for the year.  Again – it adds a very palpable sense of credibility when an organization has formally documented and maintains its projections for the year.

05. Allows for more comprehensive and accurate contingency & growth planning

This is an extrapolation of item 2 – but if you have your “most likely” scenario already documented, that makes it all the easier to map out what a best-case or worst-case scenario looks like as well.  Many economists and market analysts are much smarter than I have predicted the next recession could come sometime in the next 12-15 months.  How could a mild recession affect your business?  What decisions would have to be made in the event of a recession and how c an you plan for one starting today?  Having a formal budget allows you to do that much more fluidly. 

On the flip side, what happens if sales take off unexpectedly?  Managing through growth can be just as difficult as managing through tough times as it typically requires a lot of resource and cash planning to maintain the growth without compromising consistency in operations and profitability.  Again, I’ll reiterate: Having a formal budget already outlined allows you to better plan for these scenarios as well.