You know it’s important to weigh the costs and benefits before committing resources. So what are the crucial strategies when preparing a budget? How can you use past financial data to inform your assumptions? And how can you ensure your budget will help you meet your strategic goals? This advice, adapted from the book Finance Basics, will help you better understand how to create a useful budget.
Budgets should be ambitious but realistic. Don’t map out a budget that you can’t meet—but don’t underestimate the possibilities. Here’s how to begin.
First, list three to ﬁve goals that you hope to achieve during the period for which you are budgeting. For example:
Increase gross sales by 5%.
Decrease administrative costs as a percentage of revenue by 3 points.
Reduce inventories by 2% by the end of the fiscal year.
Make sure those goals line up with the organization’s strategic priorities.
Next, ﬁgure out how you’ll achieve them. (Remember that a budget is just a plan with numbers.) How can you generate more revenue? Will you need more sales representatives? Where can you cut costs or reduce inventories?
The smaller the unit you’re focusing on, the more detail you need. If you’re creating a budget for a 12-person sales ofﬁce, you typically won’t have to worry about capital expenditures such as major upgrades to the building. But you should include detailed estimates for travel costs, telephones and utilities, and office supplies. As you move up in the organization, the scope of your budget will broaden. You can assume that the head of the 12-person ofﬁce has thought about printer cartridges and gasoline for the sales reps’ cars. Your job now is to look at big-picture items such as computer systems and to determine how all the smaller-scale budgets ﬁt together.
Other issues to consider when you’re preparing a budget:
Term. Is the budget just for this year, or is it for the next ﬁve years? Most budgets apply only to the upcoming year and are reviewed every month or every quarter.
Assumptions. At its simplest, a budget creates projections by adding assumptions to current data. Look hard at the assumptions you’re making. Let’s suppose you think sales will rise by 10% in the coming year if you add two more people to your unit. Explain what you’re basing that assumption on, and show a clear connection to at least one strategic goal (in this case, it’s probably to increase sales by a certain percentage).
Role-playing may help you here. Put yourself in the position of a division manager with limited resources and many requests for funding: Under those circumstances, what would persuade you to grant a request for two additional staff members?
Articulating your assumptions
Usually, budgeters take the previous year’s budget as a starting point. If you’re the manager of the Moose Head Division at the fictional company Amalgamated Hat Rack, for instance, you might look at the 2014 budget to get ideas about how to increase revenue, cut costs, or both. (See the ﬁgure below, “Moose Head Division, Amalgamated Hat Rack.” Note that the parentheses in the table indicate unfavorable variances.)
Don’t look only at speciﬁc revenue or cost line items, because revenue and costs are closely linked. Instead, ask yourself what the budget shows about last year’s operations. As the table shows, the Standard Upright and the Moose Antler Standard exceeded sales expectations in 2014. Perhaps it would make sense to increase your sales projections for those products, particularly if your sales reps are optimistic about the prospects for more sales. The Standard Upright might be a particularly good choice, since it beat its 2014 projection by 9%. Could you increase the anticipated sales for this model by 5% or 10% in 2015? How much more would you have to spend on sales or marketing to achieve this increase? To make the decision, you’ll need as much data as you can get about pricing, competitors, new sales channels, and other relevant issues.
Alternatively, you might plan to eliminate some products. The Electro-Revolving model, for example, is faring poorly. Would it be better to cut this line and promote the newer Hall/Wall model? That would eliminate $81,250 in sales, but the Electro-Revolving is expensive to produce, so discontinuation might not have much impact on the bottom line.
Other questions to ask yourself:
Will you keep prices the same, lower them, or raise them? A price increase of 3% might offset the budget’s 2014 sales shortfall, provided that it doesn’t dampen demand.
Do you plan to enter new markets, target new customers, or use new sales strategies? How much additional revenue do you expect these efforts to bring in? How much will these initiatives cost?
Will your cost of goods change? For example, perhaps you plan to cut down on temporary help and add full-time employees in the plant. Or perhaps you hope to reduce wage costs through automation. If so, how much will it cost to automate?
Are your suppliers likely to raise or lower prices? Are you planning to switch to lower-cost suppliers? Will quality suffer as a result? If so, how much will that affect your sales?
Do you need to enhance your product to keep your current customers?
Does your staff need further training?
Are you planning to pursue other special projects or initiatives?
Articulating your answers to questions like these ensures that your assumptions won’t go unexamined. It will help you create budget numbers that are as realistic as possible.
Quantifying your assumptions
Now you need to translate your assumptions and scenarios into dollar ﬁgures. Begin with last year’s budget and make the changes that ﬁt your plans. If your entire staff of 12 needs sales training, for instance, ﬁnd out how much the training will cost and add in that amount. Ask your coworkers for their ideas about costs as well. And consult the websites of trade associations or trade publications for data on industry averages.
Because your budget must be compared and combined with others in the organization, your company will probably provide you with a standard set of line items. When you’ve ﬁlled those in, take a step back: Does this budget meet your unit’s goals? It’s easy to overlook big-picture goals as you get into line-by-line details. Is your budget defensible? You may be perfectly happy with it, but you’ll need to win over the budget committee. Once again, push your assumptions. Could you do with one extra staff member instead of two? If not, be sure you can make a good argument as to why not.