Thursday, October 4, 2012

The Budgeting Process - Not Pie In The Sky

When this Blogger worked for another company, every year, we did pie in the sky budgeting that never came true.   In other words, we assumed new business added to top line revenues that just never happened; but still built an expense line as though the money would be there to pay the bills.   The result was a Firm Annual Plan (FAP) that was anything but firm.   And, instead of comparing actual results to the original budget,  about every two months, our parent company asked that we adjust the budget so that there was FAP 1, FAP 2, FAP 3, FAP 4 and eventually even FAP 5.   To be candid, this process was just plain ridiculous and a bit delusional. 

That process was good experience for this Blogger.   As such, when founding our company more than 20 years ago, I was determined to implement more realistic and dependable budgeting.   While I really like the idea of Zero Based Budgeting, often discussed, where every expense is put on the table every year and justified before being approved in a new budget, that approach too is not very practical because every company goes into the year with various fixed expenses that cannot be cut.   Instead, we utilize a very practical and conservative approach to budgeting that has worked for us for years. 

First, we determine our top line revenue by modeling the likely business we are going to get from existing clients.   We include revenues from new clients signed in the the current year; but not yet fully realized on an annualized basis.   While this is only a projection of likely revenues, it is based on discussions with our clients as to likely activity in the coming year.  In other words, it is a best guess of the business we are going to get from existing clients; but at least it is better than pie in the sky that has no basis in fact. 

Once we have a top line revenue number, we then pressure test our expense line derived from our Strategic Plan for the year that is the basis for our potential expenditures.   This tells us two things.   Do we have the money to pay for the goals and objectives we have established for the year through our Strategic Planning Process.   And, if not, what are we going to eliminate because we have over reached beyond our probable revenue line.   Further, we establish our profit target through this process as well.   So if we determine we would like to achieve a 10% Pre-Tax Profit, we further add that number into the calculations.  

So, we have a probable top line revenue number likely to occur from existing clients going into the year.  This basically tells us what we can spend in order to achieve a 10% Pre-Tax Profit.  What is important in this process is that we do not include any estimated revenues from potential new clients, signed in the new year, even though we know historically there will be some new revenues.   The reason for this is that unless we were to sign new business by no later than the end of the first quarter, its probable impact on the new year would be minimal because it takes several months for our revenue streams from new business to come in the door.   Our expense line is determined by what it would take to service the business indicated in the revenue line.   Every other expense becomes discretionary and subject to prioritization. 

Some expense lines usually turn out to be a traditional percentage of our budget.  For example, we usually spend about 10% of our budget on Sales and Marketing.   For our business, this appears to be a good rule of thumb.  Clear patterns do emerge every year.    Most important, this process is worst case budgeting, rather than best case, pie in the sky budgeting that ultimately includes a basis for paying bonuses in accordance with our profitability target.   As such, we have no need to adjust our budget as was the case when I worked for another company, so we can compare actual numbers with budget on a monthly basis.    While unknown variables can impact our budget, this appears to be the best way to avoid surprises. 

Managing to a budget every month is the way to insure reasonable profitability.   For the most part, we don't spend money we don't have.   And, we rarely need to use our credit lines to fund our operating expenses, except maybe to deal with seasonal revenue variances.   We run a very tight ship, which may be the reason we have been in business for so many years, while other companies have come and gone.   This is the lesson learned.   Don't count on pie in the sky that may never happen.   If it does happen occasionally,  it just means higher bonuses, which is never a problem for anyone. 

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