Budgets are a powerful tool when done correctly. Are you using a budget? Is it helpful? Is it worth the cost in time and energy to create it?
Budget Season
As we head into the 4th quarter, it’s time to start thinking about the annual budget. Many people dread this exercise. Not only is it complicated and time consuming, but it can also feel like a complete waste of time. Others dread the process because they hate having to commit to a specific goal that they don’t know if they can achieve.
I have 6 suggestions for those of you heading into budget season:
1) Do it!
I thought everyone did budgets; I’ve learned that many people don’t. If you’re not doing a budget because you’ve never done one before, I encourage you to “level up” and start doing one. For those who are not doing budgets because they’ve had bad experiences in the past, I encourage you to think again. Don’t “throw the baby out with the bathwater.”
2) Clarify the Purpose
Budgets are used for a variety of reasons. Sometimes these reasons are contradictory. We run into problems when we use the same budget for contradictory reasons. For example, when you’re planning your purchases, staffing levels, and production volumes, you want to be as realistic as possible and as close as possible to what the numbers will actually be. If your boss uses the budget to calculate your bonus, you’re probably tempted to “sandbag” your numbers. Alternatively, if scarce internal resources are allocated based on budgeted volumes/profits, you may be tempted to inflate your numbers. Ask yourself, “Who will be using this budget, and what will they be using it for?”
It’s okay to have multiple budgets so long as people understand why there are multiple budgets and why they don’t match. Many companies have one budget for their board and a different budget for their internal scorecards. In many companies the Sales budgets might be more optimistic and may not line up with the more realistic Operations budgets used to purchase supplies, equipment, etc. Sometimes it’s helpful to use different terms for these different budgets. You might call the Sales Budget your “Sales Goals” or “Sales Strategy” and the Operations Budget your “Operations Forecast” or “Operations Plan.”
3) Keep it Simple
Don’t require every team to budget every single line item of the P&L for every single month of the coming year. Too much detail tends to make budgets less accurate. It often works best to start with last year’s numbers, adjust for the big anomalies that occurred last year, and then use that as the starting point for next year. Add in the known big changes to expect for the coming year (large contracts won/lost, vendor price increases, employee cost of living adjustments, etc). Then, fine tune the numbers until they “feel” right. Most teams ought to be able to complete their budgets in just a few meetings. It’s easy to spend much more time on the budget, but all the extra time rarely translates into a “better” budget that better predicts the unpredictable.
If there is a big constraint on the supply or demand side, it’s best to budget/forecast that item first and then optimize everything else in relation to that constraint.
4) Use it!
Your budget numbers should be listed on every relevant report. Don’t let it be forgotten. Don’t make it a secret.
5) Adjust When Necessary
Sometimes a big disruption to your business makes the original budget irrelevant. Sometimes it’s a good thing (landing a huge new contract!) and other times it’s a bad thing (coronavirus shutdown!).
If you’re using your budget to set performance goals, you should consider updating your budget to incorporate big disruptions. Generally, “goal” budgets shouldn’t be updated more than once or twice a year. Also, be sure to clarify to the team how this adjustment affects their bonus.
If you’re using your budget as a forecast to order supplies and schedule work, then you’ll want to update it as often as reasonably possible. “Forecast” budgets should be like the weather forecast – they should be timely, accurate, and tell you what you need to hear, not what you want to hear.
6) Do Your Best
In uncertain environments, it’s sometimes best to have a “do your best” budget. For example, when the world shut down last year in response to Covid, some leaders said, “We’re in a tough spot. I don’t know what this means for our business or how long this will last. I trust you to do the very best you can for now and we’ll update the budget when we have a better understanding and a more stable environment.”
In volatile unpredictable and uncertain environments, I still encourage people to try to provide 2 numbers. First a “tripwire” worst-case scenario number that tells people, “If we drop below this number, we’re going to have to do something drastic.” Second a more optimistic number where you can say, “If we could at least hit this number, I’d consider it a win in these circumstances.”
Southwest Airlines Case Study
The best example of budgeting/forecasting done right is at Southwest Airlines. They know exactly why they are using budgets/forecasts/plans and have optimized their systems and processes accordingly. Rather than doing one big annual budget once a year, they’ve split up the business and optimized (1) how far out they forecast each item and (2) how frequently they update the forecast.
Items are strategically budgeted/forecasted based on:
- Economic Relevance: How important is this to our economic performance?
- Variability: How often do these numbers change? How big are the changes? How predictable are the changes?
- Actionable: How quickly/effectively can we change operations to adapt to variation in this area?
For example, revenues are highly relevant to financial performance, highly variable, and very actionable. As a result, Southwest updates a rolling one-month revenue forecast every day. They’ve found that forecasting ticket sales and prices more than one month out is not accurate enough for tactical business decisions. Daily updates allow their marketing and pricing teams to make real-time adjustments to optimize revenues.
In contrast, the landing fees Southwest gets charged by airports only make up a very small portion of their expenses, don’t fluctuate very much, and there’s not much they can do about them. As a result, they simply budget for these items once a year for the next 12 months.
Fuel price forecasts are updated weekly for the next 3 months. Maintenance spending is updated semimonthly for the next 6 months. Aircraft purchases are forecasted over the next several years and only updated twice a year.
Need Help?
Do you need help establishing a budget or improving your current budget? Give us a call! Our team at DPX has decades of experience to help your team level up to better budgets that add more value and are easier to update.
