What is a budget?
In its most basic form, a budget is a forecast of business activity for a specific period of time.
Budgets are also a strategic tool to support business planning and serve as the foundation for lending or raising external funding. Budgets can measure performance, plan for contingencies, and allocate resources to specific anticipated needs. They identify the current and anticipated resources and allow for the allocation of those resources.
Although budgets often utilise historic data to inform future predictions, strategic budgets require a more active and critical approach to the figures. Rather than simply applying last year’s numbers to the coming year, strategic budgeting considers the business needs and quantifies those needs to account for changing goals, needs, and circumstances.
Types of budgets
There are many types of budgets, each serving a distinct purpose. Organisations select the type of budget that is most appropriate for the target audience, industry, business model, and strategic needs. For many companies, this means utilising multiple types of budgets across different areas.
Some common types of budgets include:
- Profit and loss budget
A profit and loss budget outlines the expected profit and loss for the business during the budgeting period. It is often prepared by country of operation and on a consolidated basis.
- Budgeted balance sheet
A budgeted balance sheet is a projection of what a future balance sheet will look like, and therefore indicates the predicted mix of assets, liabilities, and equity at a specific point in time. It indicates whether the projected financial position is reasonable and allows management to make changes to operational plans if the budgeted balance sheet contains undesirable or unsupportable scenarios.
- Cash-flow budget
A cash-flow budget forecasts when cash is coming in and going out. Its use ensures that the business has the needed cash for its operations and provides insight into when that cash will be available.
- Investment / capex budget
An investment budget plans for the funds needed to acquire and maintain assets, undertake new projects, or fund long-term growth. It usually includes fixed assets like property, plants, technology, and equipment with a useful life greater than one year.
An operating budget is analysis of income and spending across operations (e.g. sales, production, materials, administration, etc.). It can be used to see how operational costs change over time and serves as the basis for preparation in a bottom-up budget.
- Five-year plan / Investment plan
Elements of the above budgets can feed into a long-term master budget, often referred to as a five-year plan. The plan reflects the development in various business areas and how they impact the overall financial position of a company. The period is determined by a typical investment horizon. The challenge is not to produce a beautiful hockey stick figure, but rather tie it to realistic underlying assumptions.
In addition to the budgets noted above, there are numerous other types of budgets, each serving its own specific purpose. Choosing the most appropriate budget for the specific goal can help a company and its stakeholders plan for strategic and operational needs.
The conclusion of the budgeting process often includes the compilation of all budgets into a single overview of the business, known as a master budget.
There are also a variety of methods that can be used for budgeting. Many organisations use a combination of budgeting methods to meet their needs.
The most common budgeting methods include:
Incremental budgeting starts with historic figures and adds or subtracts a determined percentage to create a new budget. Incremental budgeting is commonly used because it is relatively easy to understand and fast to create. However, it can perpetuate inefficiencies, create undesired budgetary slack, and ignore external drivers like inflation or market conditions. Incremental budgeting works best when the primary cost drivers do not change significantly.
Zero-based budgeting assumes that all areas need zero, and then adds costs based on evidence that justifies the cost. Zero-based budgeting is useful for cutting costs or managing tight budgets, but it can be time-consuming. It is often used for discretionary costs.
Activity-based costing (ABC) identifies the necessary activities to meet established goals, and then determines the costs of those activities. The ABC method is precise, offering control and detail, while eliminating redundancies. However, it also very sensitive, requiring significant expertise in each activity to make numerous assumptions, which can lead to inaccuracies in the budget. It is also resource-intensive to utilise.
- Value proposition
Value proposition budgeting prioritises all corporate activities and then assigns value to them based on importance, generally in conjunction with another type of budgeting. Value proposition budgeting can be good for identifying which activities are creating the most value, but it can be challenging to quantify the value of activities that are not directly linked to revenue.
Budget purpose informs method
The purpose of the budget should inform what method is chosen, and therefore what information is included. Some considerations when selecting a budgeting method include:
Budgets intended for different audiences may require different content or perspectives. A board, a parent company, or management may have distinct uses which should be taken into consideration when selecting a budgeting method. Budgets are also often reviewed during transactions for information about historic performance accuracy. This potential future use may also be a consideration in selecting the most appropriate budgeting method.
- Direction: Top-down
Top-down budgeting can increase speed and overall strategic alignment, but may sacrifice detailed knowledge of each department’s needs and increase the likelihood that a department cannot operate within the established constraints. Top-down budgeting works well for companies that are growth-focused because it allows leadership to establish and convey strategic goals through budget allocations. It is also well-suited to smaller organisations, where upper management has a realistic understanding of departmental needs and happenings.
- Direction: Bottom-up
Bottom-up budgeting empowers employees and utilises their expertise to create more accurate budgets, but often takes longer. It may create departmental silos or not fully incorporate the overall needs of the organisation. Bottom-up budgeting is useful for large organisations with multiple tiers of management. They often use bottom-up budgeting because it allows top management to understand the specific needs of each division. It also engages mid-level managers in the budgeting process, which drives buy-in and improves trust in the final budget. Top-down and bottom-up budgeting are often used together. Establishing a top-down budget for overall allocations ensures that all divisions are aligned toward an overall strategy, while using bottom-up budgeting within specific divisions builds trust while ensuring that the necessary detail and accuracy are included.
The needed specificity of a budget varies based on the organisation and its goals. Companies operating in the billions may not need or want to report on all areas down to the single kroner. Instead, grouping expenses into categories so that they can be reported in thousands of kroner may be a better use of the time and resources devoted to budgeting.
Companies with smaller budgets or those especially concerned about cutting costs or controlling in specific areas might benefit from a higher degree of granularity.
Different industries have different budgeting needs. Some figures are more commonly reported or emphasised in specific industries. For example, accurately differentiating between cost of goods sold, operating expenses and overhead can seem irrelevant for Software as a Service (SaaScompanies that lack traditional costs like land or heavy machinery, but instead have significant personnel and cloud-based expenses. However, accurately reporting on variable costs provides the budget receiver with a realistic understanding of which costs will increase proportionally with sales and is therefore an important consideration in a company’s valuation.
Select the right budgeting period
Although most businesses make an annual budget and update it on a quarterly or semi-annual basis, budgets that correspond to other timeframes are more helpful in ensuring that the company’s goals are supported. Matching the budgeting period to operational timelines, billing cycles, or strategic planning timeframes can keep resources and goals aligned.
A shorter budgeting period may work best for start-ups that cannot realistically plan more than a few months in advance. Similarly, truly agile organisations, those in turbulent markets, or organisations that are significantly impacted by unprecedented external changes like a war or pandemic, could benefit from more frequent budgeting with shorter budgeting periods.
Alternatively, larger or more established organisations with long-term projects or strategies may need longer budgeting periods to ensure that all stages of the long project have the needed resources.
Putting the budget together
Once the primary elements of the budgeting process are determined, the company is ready to make some final considerations before putting it all together.
A budget is only as good as its inputs. Organisations need to have a strategy in place to validate budget inputs and create trust in the data. Comparing to historical data, confirming price times quantity, reviewing costs allocations, researching peers and competitors, and aligning with strategy can all help to build trust. A strong communications strategy that clearly identifies the purpose of the budgeting process and engages included employees in the process can also be essential in building trust.
Cohesion across budgets is also an important part of the budgeting process. All involved sections of the company should have a shared understanding of their responsibilities and how they fit together, despite utilising different types and levels of budgets. At the end, the final line items should match, so that everyone has the same values for R&D or marketing, regardless of how their budget was developed. Budgets that lack cohesion are ineffective for supporting a single strategic direction.
Finally, companies should remember that external factors can affect budget values. Exchange rates, inflation, and other market and global factors can impact the accuracy and therefore the utility of any budgeting process.
Budgeting in listed companies
We often see that owner-led companies going public lack the necessary preparation for their new existence as listed firms. Listed companies must disclose their expectations and disclose whenever they receive information that could change those expectations. This requires management to have a well-prepared budget linked to activities. In general, becoming a listed company requires preparation and a professional finance organisation.
Budgeting well is worth it
Matching the budgeting process to the budget’s goals is the best way to make sure that the resources devoted to budgeting create value for the business. Companies that are going through a transaction or internal transition can benefit from external guidance to make sure that their budgets work for them and support their goals. For all companies, budgeting can be a big task, but with right perspective and expertise, it is worth it.
Need help to improve the quality or accuracy of your budgets? Looking for a second opinion on your investment plan? We have worked with several clients on challenges like these – reach out for chat on how we can help your organisation too.