Below is a guest blog post by Romesh Jeyaseelanayagam of The FD Consultant.
They provide fractional finance directors to growing business.
Giving the benefit of their financial acumen at a lower cost than employing full time.
What is a budget?
A Budget is an estimate of income and expenditure (which can also include available capital and net assets) for a set future period of time. It is a quantified expectation & framework for what a business wants to achieve both financially and operationally – building on past performance and, if done well, providing an effective tool for forecasting ahead.
Stated in the simplest terms, a budget is a financial plan for where a business wants to go.
Why?
There are many business advantages to producing a detailed budget.
Plan for the future
The actual process of budgeting requires the business to better define company objectives, and encourages a business to articulate its vision, strategy, and goals.
Benchmark
A budget provides a reference point and benchmark to gauge and monitor performance. It gives the management team transparency & clarity with respect to actual business performance versus expected/estimated performance. It is vitally important for senior management to understand why reality differs from expectations, both good or bad.
Identification of challenges ahead
Budgeting can help identify problems before they occur.
Such as the need to raise finance or cash flow difficulties. Knowing what your potential challenges will be in advance is a big advantage in assisting management to successfully navigate these issues.
Accountability
Aiding both accountability and staff motivation, a budget can be set up to make each dept/individual manager responsible for their own cost centres. This is done by involving them in setting up the budget and therefore buying into the plan. And of course actual results can then be tracked against this plan, enabling monitoring of departmental performance (in addition to overall performance).
As well as setting targets for cost centres, by clarifying and agreeing sales targets, the sales team is also held accountable, especially as they have contributed to the process.
Better decision making
A good budget ultimately helps decision making become quicker and easier.
Management may set and change priorities as required – enabling them to manage finances, cashflows and operations more effectively as they compare actual performance against the budget plan.
Resource management
Putting together a comprehensive budget encourages management to fully consider the allocation of appropriate resources to projects. This helps with staffing requirements and matching resource to activity.
Stakeholders
3rd party stakeholders in the business – eg banks, investors, leasing companies, landlords – will be reassured with a well presented annual budget process and plan as this indicates a strong, well managed, organised and reliable business which will provide enhanced reporting of performance.
Internal discipline
An annual budgeting process, involving all relevant internal teams within the organisation, encourages cross departmental coordination and sets a firm framework with deadlines which aids the sense of discipline and structure within the organisation. These are all key components to business success.
Improved performance
Ultimately, a good budget helps drive profitability by enabling improved focus on increasing sales and managing costs.
Budgeting considerations
Managing a successful budget process and outcome is an involved process and must be handled carefully to achieve the desired outcomes. Here are some points to consider.
Time and resource intensive
Putting together a budget for the first time in particular can be a big internal project which is both time and resource intensive.
Going forwards, the time involved is lower if there is a well-designed budgeting procedure in place, and employees are accustomed to the process.
Gaming the system
An experienced manager may attempt to introduce budgetary slack, which involves deliberately reducing revenue estimates and increasing expense estimates, so that he can easily achieve favorable variances against the budget. This can be a serious problem, and requires considerable oversight to spot and eliminate.
Internal friction
If a department does not achieve its budgeted results, the department manager could blame other departments that provide services to it for not having adequately supported their department. It is beholden upon senior management to manage this risk and ensure each departmental head takes full responsibility for their performance.
Similarly, the budget may prescribe that certain amounts of overhead costs be allocated to various departments, and the managers of those departments may take issue with the allocation methods used. Again, senior management needs to balance this process so that all parties buy into the final signed off budget.
Spend it or lose it
If a department is allowed a certain amount of expenditures and it does not appear that the department will spend all of the funds during the budget period, the department manager may authorise excessive expenditures at the last minute, on the grounds that their budget will be reduced in the next period unless they spend everything authorised in the current budget. Senior management need to be aware of this risk, again to manage with clear communication and guidelines.
Finance focused
Budgets can be primarily concerned with financials – they may not deal adequately with more subjective issues, such as the quality of products or services provided to customers.
Budgets may not also encompass any review of the risks to which the business is subjected. It is important that the leadership team considers these aspects and risks when formulating the budget.
Strategic rigidity
When a company creates an annual budget, the senior management team may decide that the focus of the organisation for the next year will be entirely on meeting the targets outlined in the budget.
This can be a problem if the market shifts in a different direction sometime during the budget year. In this case, the company should be nimble and flexible enough to shift along with the market, rather than adhering to the budget.
Summary
An annual budgetary process is beneficial to businesses in many ways.
However, leadership teams need to be aware that putting together a good budget needs to be well structured and encompass many considerations.
If managed well, a budgeting process can help senior management gain improved insight into their business and make better decisions more quickly, which can only help the business thrive.
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