One of the tried and true processes at the end of each year is generally preparing the coming year’s budget. Ah yes, a time to bargain for new office equipment and bribe your corporate controller for a pet project funds.
Generally, it’s not that cutthroat, and in all actuality, a budget is a pretty useful tool to keep your company on track. In this, the first part of a two-part series on budgeting, we’re going to talk about different approaches to the budgeting process, some pros and cons of each, and why a budget is such a critical control for any organization. The second part will focus on the actual steps in budgeting and factors to consider when you’re BYOB…
The most common approach to the budgeting process is incremental budgeting. For this method, you take last year’s budget and apply a percentage up or down based on the current year’s performance. So, if net income for the current year is up 8%, that means you can take the budget for the current year and increase next year’s by 8%. This method is straightforward to understand, and it is a reasonably forthright approach. However, using this method disincentivizes leaders to think critically about the budget details and perpetuates inefficiencies and excess. For a company heading into the future that knows it needs to run lean, this probably is not the best approach.
Activity-based budgeting begins with an anticipated revenue target in mind and then determining the level of expenses that are acceptable for you to achieve a specific profit margin. This approach is very useful not only at a corporate level but especially when evaluating the performance of product lines.
Limiting expenses to a specific portion of revenue can lead to innovation and encourages running lean operations.
The major drawback with this methodology is that if revenues don’t stack up to projected levels, additional cuts will have to be made, or profit margin will have to be sacrificed. These types of adjustments are difficult to make on the fly.
Value proposition budgeting is an approach that centers around three fundamental questions:
- Why is this type of expense included in the budget?
- Does this expense create value for customers, staff, and owners?
- Does the value of this expense outweigh its actual cost? If not, are there supplementary reasons why this expense should be included?
This is the Marie Kondo approach to budgeting, where you ask whether or not an expense sparks joy. When you evaluate each expense category or type, the process inherently seeks out efficiency. However, whoever is the final arbiter of budget, the final approver, has tremendous power in approving or denying expenses, and that can be tricky.
Zero-based budgeting is my favorite because it is the most thorough. With zero-based budgeting, the assumption is that every department begins at zero and builds a budget from the bottom up. Using this method, every expense is considered every year, and searching for efficiency is optimum.
When a department head has to make cuts in order to get everything they want for the year, they will automatically seek out the most cost-effective options to maximize value.
The most significant drawback of this process is that it is incredibly time-intensive. Generally, this method is employed only every couple of years as a way of trimming the fat or when economic conditions dictate a need for a fresh slate, i.e., in a pandemic.
Whatever methodology you choose, remember why you are building your budget. Having a budget and routinely monitoring performance against it is a fundamental and critical internal control function. For example, budget to the actual analysis of payroll costs can help identify when there are ghost employees being paid through payroll. Deviations in the cost of goods in a manufacturing environment can indicate theft or inefficient use of raw materials. As a business leader, ensure that department heads and key members of management have an understanding of the budget and other important key metrics. Often these items serve as early warnings that operations are amiss, as long as you’re looking for the right signs.
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