Entrepreneurs are often lousy number crunchers. It's vital they try harder, because a well-prepared budget will save a company from no end of trouble.
Most people benefit from a little creative fantasy in their lives. But when it comes to creating the annual budget, pull your head from the clouds.
Workable figures require facts, firm assumptions and full managerial co-operation. The budget is a business fundamental, the primary control tool which management uses to monitor the progress of the business during the year. It sets out in financial terms management's vision of how the company should develop in the short to medium term and is a vital defence against bankruptcy.
The principle of budgeting is simple. Build up a monthly profit and loss account, starting with the sales forecast for the year. Estimate your associated business expenses, remembering both fixed costs and those that vary with production and sales volume. Assumptions about sales and purchases will affect figures for debtors and creditors, so a balance sheet should be prepared after the P&L, not the other way round. The balance sheet provides reassurance that the figures add up correctly. Finally, feed the figures through to a monthly cashflow statement to make sure that the company can pay its bills.
The outline is well established, but the detail and timing are less obvious.
The budget for the coming year should be prepared in reasonable detail.
But most businesses benefit from looking ahead at least another two years to minimise the risk of the company being caught off guard by large, unusual expenditure. 'It means you avoid the problem of dropping off the edge of the universe as you approach the end of the year,' says Danielle Stewart, partner in the London accountancy firm Warrener Stewart. For example, with the approach of the millennium, companies should have been budgeting ahead for the cost of updating software.
With budgeting, timing may not be everything, but it is important. Leave it too late and the business may be exposed to unforeseen events at the start of the next year. Start too early and factors may change. 'Realistically, the best time to do the budgets for the next year is three months before this year end,' says Andrew Godfrey, head of growth and development services at Grant Thornton.
Responsibility for the budget should rest with the finance director, if there is one, or the managing director. But while acting as the co-ordinating linchpin in the budget process, they should not churn out the figures by themselves. Involving relevant managers increases accuracy, while improving the chance that the budget will be seen as a useful tool.
'The objective is to have a realistic forward plan that everyone has bought into,' says Godfrey. 'You need to make sure that everyone is happy that the budget is achievable.'
The sales department also has a key role to play. 'In telling you what capacity they have, or what sales they expect, they make the figures more accurate,' says Stewart. 'It also gets them on board in terms of achieving those figures.' The sales head should be responsible for feeding through realistic estimates which take into account market conditions. The figures emerging from the sales department should then be vetted by the production departments to make sure sufficient capacity exists to fulfil them.
Against the estimates of revenue come the prediction of costs. Again managers responsible for expenditures should be consulted. Capital expenditure estimates will generally come from the production estimates. The finance department will contribute figures for other general costs, such as rent and salaries. All the items that appear in a normal P&L should be covered in the budget, not forgetting VAT, a common omission. Stewart advises budgeters not to get 'too hung up on exact timing of payments'. There is little point worrying about the exact week or month a payment is due, certainly for smaller items.
'Make sure you take account of the big bullets,' she says, such as payment of VAT or rent. 'Take account of the big items that come regularly, but don't worry about how the little things fluctuate.'
Given that the budget covers the unknown future, assumptions have to be made. A small amount of effort can improve accuracy. 'With a limited amount of research you can get a feel for what economists think the interest rates will be over the next three-year period,' says Conroy. 'You can get a feel for inflation rates. If you know you will be due for a rent review, make assumptions based on the rates being paid locally.'
Setting the budget isn't the end of the story. 'Budgeting should not be looked upon as a once-a-year operation,' says Godfrey. 'A company should update it, and roll it forward.' How often you review the budget depends how often you prepare management accounts, but at a minimum you should check performance against budget every quarter.
As with forming the budget, responsible managers need to share the review process. Depending on the size of the business the review could be structured around a regular meeting where managers report on performance, explaining budget deviations and discuss whether strategic action is required. For example, if stationery costs have exceeded the budgeted amount because a supplier has increased prices, it may be worth looking around for another source.
The most common cause of deviation is the failure to meet sales targets.
If that happens, you need to check that overhead costs can still be covered.
Fixed costs such as rent and rates don't fall just because sales do.
Managers could be required to draft short, sharp reports setting out the main points and conclusions from the budget review. But make sure you don't overdo the bureaucracy. If too much management time is swallowed up in reports and meetings, the process can itself become a drain on efficiency.
Of course, budgeting is easier said than done for a small company. Formark, a Croydon-based scaffolding business with 21 employees and turnover of around £600,000, has been working with its financial advisers BDO Stoy Hayward to draw up the budget for the next three years from 1 January 1998 onwards. Formark's finance director Mark Endersby says: 'Launching a business allied to the construction market in 1992 meant we have had a very volatile growth period. There have been periods of high activity followed by deep troughs and that makes it very hard to set budgets and stick to them hard and fast,' he says. With an increasing client base and more stable turnover, a key element of the company's forecasting is to ensure sufficient funds are available to finance growth. Assumptions about future sales form the starting point for the process, with labour as the main variable cost.
Endersby believes that budgeting is a different type of process for small and large businesses. 'Banks pay a lot of attention to budgeting as evidence that the business is under control,' he says. 'But in a small business you are so hands-on and so actively involved, you tend to know what's going on anyway. There has to be an element of gut feel. The bigger a company gets, the more senior management has to use the budget as a control point.'
Nevertheless, even a small business like Formark recognises the value of budget planning. 'In our sixth year, as senior managers have become busier, we have introduced monthly management meetings,' he says. 'We look at the results of the previous month, analysing what the forecast said, the actual sales, what we spent and revising the forecasts if required.'
Budgeting doesn't have to be a tortuous experience. Allow enough time, check all large items are included, involve relevant managers and opt for realism over fantasy. That way you achieve a reliable, focused budget that gives the business a sense of direction and minimises the risk of unexpected deviations from its desired growth path.
Zero-based budgeting - painful but necessary
For those who want to venture beyond annual budget basics, zero-based budgeting provides more strategic input. 'Zero-based' means starting with a clean sheet. And on that sheet you can begin to redesign your whole company to match the reality of the marketplace. Ignoring, for example, the fact that the company already has a sales team of ten, consider what size of sales team is really required. 'It's somewhat akin to business process re-engineering,' says Godfrey. 'Unfortunately it can be very uncomfortable to go through, but it is a valuable exercise because inevitably you build inefficiencies into a company.' The process doesn't need to happen every year, but perhaps every five to seven years. Godfrey says that now would be a good period for going through the zero-based budgeting experience. 'People are doing quite well at the moment and that's usually a time when fat is allowed to grow on the corporate body,' he explains. 'Each department should take a look at itself and challenge the way it operates. It could be quite a big job, but fighting the battles afterwards will take even more time.' In other words, handling vested interests. Partly for the sake of objectivity, and partly because the process can be complex, outside professional help may be needed. But be warned - the repercussions of zero-based budgeting can be serious. As Godfrey points out: 'Most people don't like doing it, particularly if, as a result, they decide they don't need themselves.'
SUCCESSFUL BUDGETING TIPS
- prepare the annual budget at least three months before year end
- start with the profit and loss, then do the balance sheet and cashflow budget one year ahead in detail and do a rough plan for the next two years
- make well-thought-out assumptions - don't just use last year's because they are handy
- involve departmental managers in order to form both a genuine consensus and improve accuracy
- don't get bogged down in small detail, but do cover all major items review actual performance against budget at least on a quarterly basis
- look for significant deviations from budget and investigate their causes.