Business budget for an established company: from this year to next

Everyone knows the quickest way to draw up a business budget: take this year's figures, add a little to revenue, do the same for wages, and you are done. The trouble is that such a budget locks in exactly what happened this year, mistakes included. A cost line that got out of hand becomes the norm. A customer who is about to leave is still in it. And the money goes to the same places as last year, even if the strategy calls for something else.

That last point is well researched. McKinsey looked at more than 1,600 US companies and found that for a third of business units, the capital allocated in a given year was almost identical to the year before, with an average correlation of 0.99 (source: McKinsey, March 2012). A good budget therefore starts from the plan, not from the previous budget.

What is a business budget?

A budget is the financial translation of your plans for a given period, usually a financial year broken down by month. In an established business it normally consists of an operating budget (revenue, costs and profit), a capital budget and a cash flow forecast. Budgeting is the process of drawing up, aligning and approving that budget.

A budget has to do three things at once: set a target, provide a forecast and allocate resources. BCG and the Beyond Budgeting Roundtable point out that these three clash: an ambitious target is not a realistic forecast, and anyone who wants budget has an interest in forecasting low (source: BCG, September 2021). Even so, the budget remains the standard tool. In a survey of 558 North American organisations, 79% used budgets for control, and 94% of those had no plans to stop (source: Libby and Lindsay, 2010). Organisations adapt how they use the budget rather than abolish it.

A startup budget or a budget for an established business

At startup everything revolves around assumptions, because there is no history yet. For that situation Firmfocus has separate articles on startup costs, the profit and loss forecast and the cash flow forecast for startups. An established business has something a startup lacks: figures from the past. That makes budgeting more accurate, but also more treacherous, because history all too easily becomes the future.

Top-down, bottom-up or driver-based

In practice a combination works best: management sets the framework and the targets, departments fill in the detail from their drivers, and one round of alignment follows. In its research among finance functions, Deloitte found that almost half look only at financial outcomes and not at the drivers behind them (source: Deloitte, April 2023). If you know the drivers, you also know where to intervene when the figures disappoint.

How to make a budget for a business in seven steps

1. 01

   Start with the annual plan

   Which goals and initiatives are in the annual plan? They determine where extra money goes and where you deliberately spend less.

2. 02

   Clean up the current year

   Take this year's expected outturn and strip out one-off items: a large damage claim, an exceptional order, a vacancy that stayed open for months. What remains is the underlying level.

3. 03

   Build revenue from drivers

   Customers times orders times average order value, or capacity times utilisation times rate. Use price increases you can genuinely pass on and the customers you genuinely expect. See also pricing.

4. 04

   Derive direct costs from revenue

   Purchases, materials and subcontracted work move with revenue. Budget them through the gross margin per product or service, not as a fixed amount.

5. 05

   Budget staff by role

   For each role: the number of FTEs, pay, the increase under your collective agreement or pay policy, employer's on-costs and the date someone joins or leaves. For many businesses staff costs are the largest item and the hardest to reverse.

6. 06

   Go through other costs and investments

   Premises, vehicles, IT, insurance and professional fees: check each item against contracts and price agreements. Put investments in the capital budget and include depreciation and interest in the operating budget.

7. 07

   Spread across the months and test

   Spread revenue and costs according to the seasonal pattern of previous years, prepare the cash flow forecast and set the outcome against your sector. More on that below.

Worked example: a car body repair shop

A body repair shop with eighteen staff works for private customers, leasing companies and insurers. The annual plan focuses on winning more work from leasing companies and on shorter turnaround times. This is how the budget translates that.

Fictitious Firmfocus example. Amounts rounded.

Two things stand out. Revenue growth comes from higher utilisation, not from a general growth assumption, and every month the workshop manager can see whether that utilisation is being achieved. And the budget includes the new spray booth, but also the extra panel beater needed to keep the booth busy. That is how plan and budget hang together.

Is your budget realistic?

Budgets are almost always too optimistic, both about revenue and about how quickly new plans will take effect. Daniel Kahneman and Amos Tversky gave this a name in 1979: the planning fallacy. When you make a plan, you look at the details of your own plan and underestimate what can go wrong. In Harvard Business Review, Dan Lovallo and Kahneman set the outside view against it: look at how similar cases turned out. Bent Flyvbjerg developed this into reference class forecasting, which takes three steps: choose a group of comparable cases, establish how their outcomes are distributed and place your own plan within that distribution.

For a budget, your sector is such a reference class. Three tests you can run in an hour:

• Cost structure: compare staff costs, purchases and other costs as a percentage of revenue with the sector average, using the profit and cost benchmark. If your budget differs sharply, you should be able to explain why.
• Growth: compare budgeted revenue growth with what your sector has shown recently, using the sector figures. If you are growing much faster, which concrete plan explains it?
• Your own track record: how far did actuals differ from the budget in previous years? If you were consistently too high, you probably are again.

Also work with a low, a middle and a high scenario for revenue. The budget follows the middle scenario; test the cash flow forecast against the low one.

Budgeting in a spreadsheet or a planning tool

For most small and medium-sized businesses, a well-built spreadsheet does the job. Put the assumptions on a separate tab and the months in columns, and calculate everything from those assumptions, so that one change does not mean editing a hundred cells. Add a column for the monthly actuals and you can use the same file for the monthly report. In the Business Planner you record the operating budget, the capital budget and the cash flow forecast together with your plan.

After approval: tracking and adjusting

A budget nobody looks at after January has mainly cost time. Compare actuals with the budget every month and, where the variances are large, find the cause: price, volume, mix or efficiency. That is the subject of management reporting and variance analysis. If something fundamental changes, update a forecast rather than the budget itself. That way the budget remains the reference point and the forecast shows where the year is heading.

SMEs and large organisations

Large organisations that want to limit the drawbacks of the annual budget look at zero-based budgeting and Beyond Budgeting.

For how the budget fits into the wider cycle of planning, measuring and adjusting, see planning and control.