Budgeting: An In-depth Guide to Business Budgeting
Budgeting can be a remarkably hectic process due to its immense importance for effective financial management, be it on a personal or organisational level. This guide will help you understand the different methods and types of budgeting techniques that you may use during your financial planning process and will also expand your horizons to how you should expect budgeting to go about in the future.
Our business advisors often deal with questions about the budgeting process like where to start or which elements to include. As effective budgetary planning and control ensure that your business is well aligned with its objectives, it is necessary to have the right answers to all your concerns. Our objective within this article is to discuss the essential components of a budget and how budgets may differ according to business types and objectives to provide business owners with the right direction to improve their budgetary efficiencies.
But before diving deep into the nitty-gritty of the process, one must know what the term budgeting stands for and avoid any confusions with similar terms like forecasting to utilise budgetary activities in the best way possible and therefore our expert accountants are here to help you with that.
What Is Budgeting?
Budgeting is the process of making a financial plan for your business while keeping resources and business objectives in mind. It is the basic tactical implementation of your business plan, which looks at the estimated inflows and outflows over a specific period in the future. Budgets act as a financial roadmap for your business to understand the anticipated expenses and incomes within a set period, eventually serving as a planning, forecasting, comparing, and control tool for your business activities.
Businesses use planning, forecasting, and budgeting as all these functions play an essential part in the financial management process; however, they each perform distinctive roles.
The Difference Between Planning, Budgeting, and Forecasting
It is useful to understand the difference between these three terms as together they help analyse and evaluate your business’s financial performance and suggest explanations to challenges.
A good plan will allow your business to stay focused on achieving short- and long-term goals and within the scope of planning lies financial forecasting and budgeting. These are the two main planning tools used by modern businesses. However, in many cases these two terms are confused.
Let’s have a look at how budgeting and forecasting differ significantly.
Why Should You Budget for Your Business?
Budgeting is an essential process that your business must carry out, regardless of your business size or age. Budget performs as a crucial management tool along with planning, collaborating, cost management and cash flow analysis which allows a business to form a pathway to financial success while opening business expansion opportunities.
It is essential to understand these tools one by one.
Budgeting acts as a planning tool for managers as they financially plan resources according to the desired objectives. This budgetary planning process allows managers to learn from their past mistakes and opt for better planning strategies in the future.
For example, once you decide to increase revenues by 20% in the next year, the budgetary planning process will reevaluate your previous revenues and expenses and devise appropriate strategies that your business must adopt in the future.
The concept of collaboration depicts the practice of working together for a common business purpose. Likewise, different departments within your business may construct their budgets and collaboratively integrate the numbers into one master budget. This way, budgeting acts as a collaborative tool to make the process simpler, relevant, and more efficient for your business.
Cost Management Tool
Cost control and cost management are among the most crucial factors for businesses in most cases as lower costs would leave your business with a higher profit margin. As most businesses set cost budgeting procedures and guidelines, it’s essential to consider some fundamental cost management factors like:
Activity Cost Estimation
Different activities that go around your business must involve cost controlling procedures to ensure that you complete your tasks within the estimated budget.
Essentials Of Estimation
Setting the basic estimated cost for your business functions will make it easier for management to decide upon suitable funding options, the cost risks, cost opportunities, and overall clarify the costs for each process involved.
The reference cost point used by your business will help you follow a specified cost criterion. Benchmarking gives the management an indication of the standard average values and variations which it can go about.
Budgeting also acts as an excellent comparison tool for managers to compare actual vs expected costs for the year. This variance analysis technique will provide your managers with adverse (where actual costs exceed expected) and favourable variances (vice versa) to reason with over or underutilised areas. Moreover, your business can also compare values with previous cost budgets to interpret changes and improve future decisions.
Cash Management Tool
Businesses mainly create cash budgets to prepare for expected cash inflows and outflows. While profit maximisation is a firm’s general motive in usual cases, a healthy cash flow is necessary for a business to function smoothly. Thus, budgets act as a necessary cash management tool to ensure that you have sufficient cash throughout the process.
After going through these tools, you must remember to start with the right mindset and ensure that you follow the correct budgeting process so that your business budget operates adequately.
The Ultimate Process Of Budgeting
How To Get Started With Budgeting?
It is useful to begin with a thought process that includes researching your product line, understanding your market competition, setting pricing strategies, controlling various areas, and looking for growth potentials. It is the brainstorming procedure that will guide you to see where to start. Once you have your thoughts in line; you must go through the common types of budgets that businesses use and decide upon whatever fits best with your current position.
The 4 Main Approaches To Budgeting
You must be well aware of the four main types of budgeting methods to decide which one to follow and further determine the degree of involvement to formulate a well-defined and non-manipulative budget.
The 4 main approaches are:
1. Incremental Budgeting
Incremental budgeting mainly involves adding or subtracting(detrimental) a percentage to the previous year figures to calculate the proceeding month or years budget. This method is easy to calculate; however, it does not apply to a start-up case. If you run a business with constant primary cost drivers, then incremental budgeting will work appropriately. However, it would be best to remember that incremental budgeting may promote inefficiencies, resulting in a budgetary slack and might result in ignoring any external economic impacts like higher inflation, thus used as an inappropriate measure of budgeting in other cases.
2. Activity-based Budgeting
This approach determines the number of resources required by the business to carry out the activities to achieve their targets. Suppose your business sets the target to make a revenue of £50 million in the upcoming year. In that case, you will first determine all the activities that must be carried out to achieve the target and how much each activity will cost.
This approach is a top-down budgeting method where the individuals responsible for the top tier structure set the organisation’s budget, leaving minimal involvement for lower positions.
3. Value Proposition
The value proposition is a budgeting approach that ensures that everything added to the budget holds value for the business so that the cost-benefit analysis is always in surplus. This approach aims to avoid any unessential expenditures (not as strictly as the zero-based budget) while mainly focusing on the value of elements added.
This approach is one of the most common methods followed by businesses as it aims to build every departmental budget from scratch. For a zero-based budget, you will be defining each expense with a justifiable reason so that all unnecessary items are excluded. This method is the most time consuming while it follows the bottom-up approach, where participation level is very high within the organisation as recommendations are made from lower position employees to top managers. The upside to following this approach is that one may use the most efficient numbers and lead their business to operational success.
The Main Components of a Good Budget:
Revenue is the sales figure you are anticipating to make in the next year. It’s the very first entry of your business budget. Your business’s income acts as a guide to your business’s trade receivables, regardless of the input costs.
You may base these numbers on last year’s performance, new objectives, or industry averages as it entirely depends on your current standing and future visions.
Fixed costs are constant costs that you cannot ignore for the fiscal year you are budgeting for, and they mainly include payments like rent, insurance, lease, and service payments.
These costs vary with the output levels and include elements like materials, packing, shipping and commission. It’s crucial to set a clear budget that involves all the expected variable costs as they sum up to become a huge chunk of the total costs.
Some costs may end up as semi-variable costs where you may be paying an employee a fixed salary per month and then a variable amount on top of it for the number of items produced. You must carefully charge the fixed amounts and variable amounts separately so that your budget is not misleading the management with the wrong numbers.
One-off costs or one-time costs are the unusual costs made by a business. These may include research and development expenses, investments in software or start-up costs. These must be included in the budget under a separate heading to adjust your next accounts accordingly.
Your budget must include cash inflows and outflows as the cash is known as your business’s oxygen. This will enable you to make supplier payments on time as you will have the most accurate and updated cash figures available.
One of the central business motives is profit maximisation. This value is obtained by deducting all expenses from your income(revenue), giving you the end value. For instance, if you decide to grow your business with tax efficient investments in the next year, your profit values may show a decline if your income does not rise with the same proportion.
After looking upon the essential components, it is now time to understand the necessary parts to prepare for your final budget to carry out budgeting proficiently.
What Budgets Do I Need To Prepare For My Business?
Be it a small or large business; once you decide to estimate your future incomes and expenses for a specified period, you will have to create a master budget. The master budget will consist of two main parts- the operating budget and the financial budget.
The operating budget will mainly include all income-generating activities such as sales, purchases, inventory, and production. Meaning that the operational budget will reflect upon your business’s income statement and operating profit margins. The budgets estimated under this category include:
- Sales budget
- Production budget
- Purchases budget
- Overhead budget
- Cost of goods sold budget
- The selling and administrative expenses budget
Finally, leading to form an integrated budgeted income statement.
Meanwhile, the financial budget mainly estimates a firm’s cash and capital budget along with balance sheet values like the assets, liabilities, and equity. The three main budgets estimated under this category include:
- Capital expenditures budget.
- Cash budget
- Budgeted balance sheet
It is vital to financially budget in the same order as shown above. You must also remember to estimate the financial budget after all the other budgets as it marks the completion of the budgeting process.
A Step-by-Step Process
The detailed elements of your master budget will surely guide you in the whole process of estimating the numbers; however, budgeting has a lot more to do than just calculating the estimated values. Budgeting is a comprehensive process with several complicated steps and so consulting your accountant can help you understand and get the overall view in an improved manner.
- Review and Revise budget assumptions whenever changes occur.
- Pay attention to available funding options and seize the best opportunity.
- Identify costing points beforehand and alter cost structures accordingly.
- Focus on departmental budgeting and combine them to a master budget.
- Cater to capital budget appeals to take smart steps in advance.
- Update budget models yearly to avoid any confusion.
- Acquire approval of the final budget from top management.
- Issue and communicate budget throughout the organisation after the approval.
- Consider setting up a Contingency budget amount to reserve a backup if your business faces an unforeseen event in the industry or economic uncertainty.
Budgeting for Different Business Types
While every reasonable budget has a practical framework, including the main processes, you will have to consider the unique budgeting tactics for your business type and modify your budget accordingly. Consulting a business advisor may help you outline the basic needs of your business to create a comprehensive budget plan.
Let’s have a look at how budgeting works for different business types:
Budgeting can be a tricky process if you are planning for a start-up. You will be researching industry averages to understand the salaries, rent payments, marketing costs and other payments such as professional fees and equipment costs. Asking around your network may also act as a guide to help you set expected amounts for each of these costs. Moreover, setting aside a specific part for budgetary advisors will enable you to save thousands on mistakes and inefficiencies you might make by not investing a few hundred.
The methodology of budgeting may work in terms of trial and error for a start-up initially; however, it is best to use simple budgeting templates and take professional accounting advice to start strong.
For a business generally functioning on inventory storage and supply, you will have to carefully forecast and estimate the expected demand for your products so that you do not run out of goods and supplies. Using previous years sales figures and extrapolation methods will guide you in setting the best estimate for the next budget. Some research over vendor prices and shipping rates will help you get the best inventory prices while focusing on fixing the least costs with the best quality in your budget.
Inventory volume will affect your budgets as bulk discounts may reduce cost per unit, eventually reducing production cost; however, you will be paying more in the same year. It is also essential that you consider storage, ordering, and handling charges to account for the leftover stock accurately.
If you run a service business that offers no tangible goods to the customer, focusing on projected revenues, salaries and consultancy costs will guide you in figuring the costs. For a service business, budgets are always flexible due to high reliance on customers fluctuating demand, cost of time and service requirement.
Custom Order Business
Custom orders vary for each customer, so labour and material cost will differ in each case indicating that you must prepare an average estimate for the orders while keeping a flexible budget in mind to avoid under budgeting.
The main element in budgeting for an eCommerce business is shipping. The shipping, packaging and import duties will massively impact your budget. Moreover, you will be investing in web services and social media marketing for an eCommerce platform to host the best online shopping platform, all adding up to your budget.
Budgeting is going to be frequently vital if you run a seasonal business. The income your winter clothing brand will generate in the winter season cannot be compared to the summers’ income. Thus, it’s vital to predict future cash flows and forecast according to trends to consider the slow months. You may utilise these slow months to improve supplier and customer relationships and strategize each season according to the new opportunities in the market.
For an IT business, your budget will not only include capital investments and usual operation costs related to hardware and software, but it will also include training and development costs for your intellectual capital, the human body.
Your sales figure may only include a quantity of 20 units while the per-unit sales might be extremely high. Therefore, it would be better to focus more on your business’s financial budget, as this would include the most influential elements of your budget.
The types of businesses discussed above indicate how different factors hold importance for various business types. At the same time, it is also imperative to understand how budgeting differs for the same business as objectives change.
Video: Budgeting and Cost Control
Budgeting As Per Different Business Objectives
If your business objective for the upcoming year is to increase profits by 15%, your management will carry out a budgeting process known as the bottom-up approach. Meaning that the bottom-line figure must be achieved, so revenues and costs will be adjusted according to that. You may increase your revenues by reducing your products’ price if the price elasticity of demand is high or cut down on unnecessary costs so that the target is achieved. Thus, adjusting the entire budget to achieve the common goal.
Increase Market Share
Businesses increase market share by boosting promotional campaigns, building a strong customer base, devising CSR programs and other suitable actions to stand out from their competitors. This budgeting process will involve the top-down approach where management may have to attain a sales figure increase by 30%. No matter how the figure is achieved by increasing costs or reducing profits, you will have to reach the target. Here your budgeting will focus on growing market influence, and so your operational costs and capital expenditures may increase vastly to attain a higher market share.
If you set a goal to grow your business for the next year, your budgets will be made with the mindset of profitable investments today to increase tomorrow’s budget limits. Your business will budget with an objective of business expansion, and so high costs will not indicate something negative for the year.
In the case where your business lies in a survival stage, breaking even will matter the most to you. Here you will strictly be budgeting and following the essential steps to ensure that you do not go in loss. Your budgets will be rigidly set, monitored, and appraised so that your survival stage is maintained to ultimate business recovery. At the same time, you look for additional ways to reduce costs and increase revenues to regain a better market position before competitors drive you out.
The financial plan’s essential purpose is to fulfil the business’s objective within a set financial constraint; nonetheless, we sometimes like to look at it as the general purpose. Budgets hold more than just the generic purpose, and it’s insightful to know about the contrary.
An Insight Into The Generic Vs Innovative Purpose Of Budgeting
The generic idea behind budgeting is to financially plan, organise and track your financial performance according to your business objectives. It varies from controlling to managing to comparing and looking for other investment opportunities, allowing you to suit the budgeting process regarding industry averages and past performances.
On the other hand, the innovative purpose of budgeting supports creativity and constant revaluation to enhance productivity. You may set a budget for research and development and make big investments, while still maintaining a disciplined procedure with a contingency plan using professional planning consultants. This purpose of budgeting promotes to aim higher and not just stick to industry averages and past performance values. Some people refer to it as a start-up budgeting process as it involves higher risk as an unexplored opportunity waiting to be seized. It’s about doing much more than what is already happening to add value to your budgeting process.
The traditional process of budgeting has been opaque and limited to specific timeframes. This has resulted in holding the business back from accelerating in the competitive business environment. As per this, the budgeting process’s future is bound to evolve, and it’s essential to stay updated to adapt to any forthcoming changes.
The Future Of The Budgeting Process
According to professionals at Clear House Accountants, budgets play a crucial role in shaping your business, and so your budgets must reflect over the latest technological innovations to reduce business risk and volatility. This means that combining effective forecasting techniques and what-if analysis, along with innovative practices, will keep your business updated and help you to make well-informed decisions to achieve your long-term goals.
Integrating your future budgeting process with the latest of technology and incorporating IT within all your operations will significantly impact your business performance. Software like Excel and budgeting tools in Xero will give your financial managers massive scope to improve reliability and informational security. In effect, emerging systems like the IFP, CRM And ERP will bring in superior automation practices for your budgeting process so that your future plans work to strategise rather than merely emphasise on the tactical approach.
Jibran Qureshi FCCA is the Managing Director of Clear House Accountants, and has over 10+ years of experience in practice and across multiple industries. Jibran’s educational background includes a Master’s in Financial Strategy from Oxford University and an Executive MBA from Hult International Business School. His experience in Financial Strategy, Tax Planning, Operational Consultancy and Performance Reporting guide his cognizant approach to leading Clear House and its clients to the future. It was this dexterity that led him to be Enterprise Nation’s Top 50 Advisors.
Jibran is fueled by his passion for helping businesses. He unequivocally believes that as business advisors and accountants for our clients, it is our responsibility to work with them as business partners. As specialists, it is our duty to help our clients navigate through the complexities of constant change and the implications that come with it.
Over the past decade, innovative disruptions have changed the way businesses work, everything from cloud software, innovative business models, to AI and machine learning, have impacted how businesses operate, grow, and expand.
Jibran recognized the need to manage these disruptions sustainably, early on and shaped Clear House Accountants to not just be compliance specialists, but advisors who help build complex ecosystems around cloud accounting software, provide advice on funding support, help manage innovative tax schemes, set up and implement complex strategic plans, and much more. So, his clients can thrive, not just survive.
Jibran developed his prime role as the Managing Director to build Clear House’s capabilities so it can add value for their clients. He is of firm belief that this can be done through consistent high-level training, building the right tools, and creating roadmaps to help businesses cope with prospective disruptions. He envisages that every client that comes on board, is provided maximum value through onboarding, ongoing services and the right mix of tools to help them become the best in the world.