Running a business poses the threat of getting lost into the day-to-day issues the company faces. And this can mean we start to miss the bigger picture. Investing time and resources in creating a budget and a business plan is essential to ensure we form a proper long-term strategy for the business.
A budget helps us to enforce spending control, which leads to proper planning and clear business objectives to achieve. It is a forecast of performance over a specified period.
Budgets serve as a plan of action for the management, and also as a reference point for performance evaluation.
Every Business needs a Budget
When we ignore the importance of budgeting, we invite issues with long-term planning and unexpected expenses. A budget can help us with short-term obstacles and strategic plans for the future.
A survey by Clutch.io found that more than 60% of small businesses skip budgeting. This is most likely due to many small business owners thinking of budgets like too restrictive of their growth opportunities. Also, such entrepreneurs usually create their own companies to escape from the administrative burdens of a large corporation.
Without preparing a budget, it is hard to identify challenges and to ensure the company has the liquidity to face them. Having a forecast for the foreseeable future helps with that and reduces the strain of monitoring our financials. When forecasting, we estimate sales and expenditures and ensure we place restrictions on spending that is not part of the plan.
When we negotiate with investors and lenders, it is beneficial if we have a strong proven track record of setting budgets and following them through.
By creating a budget, we make sure we allocate the proper funds to the strategic objectives of the business.
Value of a Budget
One of the most crucial tools for navigating the business is to have a realistic budget. It’s a framework for the company’s finances, incorporating past performance and forecasting future sales, expenses, balances, and cash flows.
Budgets ensure that all departments within the company have aligned goals. Miscommunication can lead to limitations in the long-term performance of the company. We should perceive the process as an integral part of developing the business, as it is a measuring tool to evaluate the company’s goals and performance. Budgets are extremely useful as they provide the firm with outside accountability.
Simply put, creating a budget gives peace of mind.
The Budget Cycle
We need to grasp that a budget cannot account for everything, and we should strive to avoid getting lost in too much detail. When we are preparing our forecasts, we have to leave some wiggle room. A budget is supposed to work as a guide, not a 100% accurate prediction.
One way to approach this is to add scenarios to our models. Doing so, we allow for flexibility in our budget and allow for unforeseen circumstances.
The budgeting process should start with setting clear and realistic goals for the business. However, it doesn’t end when we have prepared the company’s budget statements.
After we have prepared our forecast, we need to perform regular variance analysis of our actual vs. budget performance, to evaluate whether the company is deviating from the plan. This allows us to look into the potential reasons for underperformance and identify possible solutions.
Engaging more employees in the budgeting process strengthens their loyalty to the business, as it helps them align their values and vision with the company. Especially in larger organizations, we will ask the department heads to forecast their performance in department budgets, which will then become part of the master budget of the firm.
When evaluating performance, we use flexible budgets. Here we apply the same assumptions as in our master budget, but to unit outputs from the actual performance of the business. An example is valuing our sold quantities based on our forecasted sales price and variable costs. On this basis, we perform our Variance Analysis.
Let us take a look at some of the most common types of budgets prepared by businesses.
- The Master budget – a forecast for the company as a whole, what we usually refer to as a 3-statement budget (includes the Income Statement, Balance Sheet and Cash Flow Statement);
- Static budget – a forecast that looks at fixed costs and capital expenditures;
- Operating budget – focuses on revenue and expenses from the day-to-day operations, including the cost of goods sold, overheads and admin costs, tied to activities;
- Cash-flow budget – forecasts the cash inflows and cash outflows, focusing on when they’ll happen, to assist liquidity management and assure sufficient funds are available to the business;
- Rolling budget – these are regularly updated to add another period so that they will keep the same future outlook for the company.
Benefits of Budgeting
Creating a budget is necessary for the performance evaluation of the business to see if the company is sticking to its plans. Proper forecasting has many benefits for the enterprise, the most common of which are:
- Allows continuous tracking of the business performance;
- Helps long-term strategic planning for operating and capital expenses, and expansion;
- Ensures the timely hiring of new employees;
- Raises the attractiveness of the business for investors;
- Makes it easier to set department goals;
- Improves options to secure lending from banks;
- Allows for regular management reports and status updates to be presented to the stakeholders.
Most companies face unforeseen challenges from time to time. Budgeting provides guidelines to help managers achieve a more informed decision-making process. It aids us in performance valuation and is an essential part of forming our long-term strategy.
Spending the time to create a budget might seem like a daunting task at first, but once we consider all the benefits, it should be clear how crucial it is to set the company for financial success and growth opportunities.
Setting a plan for future performance is an integral part of running a business efficiently.
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FCCA, FMVA, Co-founder of Magnimetrics
Hi! I am a finance professional with 10+ years of experience in audit, controlling, reporting, financial analysis and modeling. I am excited to delve deep into specifics of various industries, where I can identify the best solutions for clients I work with.
In my spare time, I am into skiing, hiking and running. I am also active on Instagram and YouTube, where I try different ways to express my creative side.
The information and views set out in this publication are those of the author(s) and do not necessarily reflect the official opinion of Magnimetrics. Neither Magnimetrics nor any person acting on their behalf may be held responsible for the use which may be made of the information contained herein. The information in this article is for educational purposes only and should not be treated as professional advice. Magnimetrics accepts no responsibility for any damages or losses sustained in the result of using the information presented in the publication.