Engaging in sports and developing a business budget are two activities that seemingly have little in common, yet they share something: everyone acknowledges that they are both positive exercises for health (whether physical or financial), and yet few people manage to implement them successfully daily.
Why does this happen?
Undoubtedly, because they require time and consistency, and their benefits are not very evident in the short term. But also, in the case of budgeting for a company, because it’s difficult to understand the specific advantages it can bring on a day-to-day basis.
Advantages of Creating a Budget
Below, I’ll explain the 5 most important advantages of having a well-prepared budgeting process. I’ll also present 2 potential problems that may arise if not implemented correctly, one of which is explained by Michael Scott from “The Office” series.
Let’s start with the advantages.
- Better Understanding of Your Company
The simple act of sitting down to create a budget force one to think and understand the different parts it will comprise, as well as the level of detail required, which will greatly depend on the available information.
For example, budgeting for salaries and wages per employee is not the same as doing it without any detail, as it will be much more complicated to identify the causes of discrepancies. The same goes for the level of detail of costs or sales. If we have sales information by product, category, or geographical area, the budget is more complex, but it will also provide us with much more information.
Determining the key business indicators and the basic information needed to analyze them is crucial at this point. Therefore, the budget creation process itself will already provide us with a lot of knowledge about the company and its structure.
- Global View of the Situation
Once our budget is prepared, it’s easy to quickly identify the most important items and how they impact the net result of our business:
What percentage do operational expenses represent of sales?
What is the gross margin required to cover these operational expenses, also known as the breakeven point?
How much will high inflation next year impact the result?
These are just examples of very basic questions we need to be able to answer, and we will have the answer at hand just by looking at our budget. Projecting different scenarios by “playing” with hypotheses is very useful and will help us be prepared for any future eventuality, providing us with the information we will need in case we have to take corrective measures.
- Goal Setting
Undoubtedly, one of the keys to any budgeting process is goal setting, which will be what leads us to achieve the desired result. These goals, whether sales, costs, margins, or debt levels, must play a specific role within the overall budget.
Setting an ambitious sales goal will not have the same result as focusing on a gross margin goal or cost control. We need to know where each will lead us, how our company is positioned, and where we want to take it.
The most common thing is to establish annual sales and gross margin goals, together with an operational expense goal. Additionally, it’s important to also consider debt levels and working capital, and therefore we can also incorporate inventory turnover goals, receivables and payables terms, or total debt to EBITDA. Always depending on each case and the levers we want to use.
All these goals are defined globally in the organization and can then be cascaded down to the departmental level, business area, and employees, allowing us to create an efficient incentive system, to align interests and encourage everyone in the organization to row in the same direction.
- Decision Making
Creating a budget can never be a static exercise, it’s a living entity that we need to periodically review, adapt to changes, and improve over time.
The periodic review can be monthly, quarterly, or with different levels of detail depending on the time of year. For example, we can do a monthly review of the most important items of the income statement and key indicators, and quarterly go into more detail on all items, also on the balance sheet, redoing the annual budget by updating previous assumptions and correcting discrepancies that occurred in closed months.
It will be these moments of periodic review and analysis of discrepancies that we will take advantage of to make the corresponding decisions and correct the course that will lead us to achieve our goals:
Does the sales scenario I estimated at the beginning of the year still make sense?
Are we achieving the desired margins?
Is debt increasing?
And most importantly, what should I do to correct these discrepancies?
- Anticipating the Future
Perhaps this is the characteristic that most entrepreneurs have in mind when making a budget, as if it were an attempt to predict the future. However, we must not forget that the future is uncertain, we cannot expect to hit the monthly sales figure, costs, or margin, because the world is constantly changing and will always surprise us with something new.
The advantage occurs when we can maintain a position that allows us to be prepared for any contingency that may occur.
The main function of the budget is not to predict what will happen, but to be a tool to identify what is happening and what we need to change at any time to improve the position of our business. Knowing the available levers, we can activate to take us from point A to point B. For example, which costs we can or cannot reduce, what margin we need to achieve to not lose money while maintaining market share, which product line is profitable. In short, knowing all the cards that are in our hand to play them when necessary.
Potential Problems When Not Creating a Budget Correctly
Like everything good in life, it can have its negative side that will appear if not used or implemented correctly. I will detail 2 possible problems that we should always try to avoid when implementing a budgeting process.
A. False Comfort
Creating a budget is only part of the job. Without periodic monitoring, it serves practically no purpose. But there are entrepreneurs who believe it is something magical, and that simply by having done it, they can leave it stored in a drawer throughout the year and the stars will align for what was initially planned in the document to happen. Of course, most likely they will be surprised by huge deviations at the end of the year and the worst part is that it will be very difficult to identify what happened, what were the main reasons, and what should be changed. This is a work of constancy and consistency; it is not a sprint at the beginning and end of the year.
B. Unnecessary expenses
This last point is somewhat counterintuitive. It can arise when budgets are allocated to different areas/departments and when we do not use a zero-based budgeting system.
What can happen in these cases? Nothing like an example: as the end of the fiscal year approaches, the technical department has 10,000 euros of savings in its total expense budget. As the technical director knows that the budget, he will be assigned the following year will be based on what was spent this year (not zero-based), what he will do is spend those 10,000 euros, in any case, even on absurd things, just to create a basis for the next year. Undoubtedly, not very efficient for the company. There are several ways to correct this: the first is zero-based budgeting, that is, not using the value of the last year as a reference for the next; the second is to clean the base, or eliminate all non-recurring expenses from the previous year; another possible solution would be to give an incentive to the responsible person in the area if they can achieve a surplus at the end of the year.
I hope it has been useful. Remember that at Simplifinance we have more than 20 years of accumulated experience in budget preparation, adapting them to the needs of each company, whether large or small. If you need help with your budgeting process, do not hesitate to contact us and we will be happy to help you.”