A new year, a new set of forecasts and a new set of budgets.
Many people in business will be familiar with this, including the weeks running up to the end of the prior year where so much effort, debate and rework goes into the building of the following year’s budgets.
But why even bother?
I remember reading an article a few years ago where the author suggested that forecasting was a waste of time. His rationale was that the only time you really need a good forecast is when something major is going to happen i.e. the crash of 2008. The rest of the time things trend to a general average.
There is something refreshingly anarchic about this view, but does the same thing apply to budgeting?
In the next series of blogs, I will delve a bit deeper into budgeting. How you do it, how you monitor it; and how it links to other aspects of financial management, including cash flow.
This blog covers why budgeting is a critical component in the financial management of the business. As before, I will concentrate on five of the key reasons, all of which are interlinked.
Financial Control: A core discipline required by any business that is serious about staying solvent making money.
Planning: Much of the work required in planning is also required for budgeting, which in itself is planning.
Measuring Performance: budgets are a critical component of monitoring performance of business units, functions, products, people.
Making people accountable: there is a strong correlation between people having accountability for expenditure and better organisation control of cost.
Cash flow management: understanding and budgeting both sales and costs supports the development of an effective cash flow forecast (see previous blog).
So, some good reasons why a business should budget, but how do you do it and are all budgets the same?
The answer to the second part of that question is no. There are a variety of different types of budget and ways of managing the budgeting process. Whilst I will go into this in more depth in the next article, there are commonly three key types of budgeting:
Incremental budgeting calculates a budget by taking last year’s actual figures and applying a percentage adjustment to determine the current year’s budget.
Zero-based budgeting is very tight and only considers expenses that are essential to the company’s operation, therefore every expense must be justifiable.
Activity-based budgeting calculates a budget by determining the amount of inputs needed to hit the desired targets or outputs of the company, i.e., the cost needed to hit the target of the anticipated level of activities.
All of these have their own set of advantages and drawbacks; and the budget adopted (or mix of budgets) will depend on the individual circumstances of the business. Suffice to say, building and using a budget is a critical component of sound financial management.
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