Budgeting Techniques
Annual budgeting can be an overwhelming process. We discuss 2 different approaches to budgeting to help you with your annual financial planning.
Tune in to learn about the Lean and Waterfall budgeting methods.
PODCAST TRANSCRIPT
Darell Brown:
Welcome to the ProProject Podcast with ProProject Bookkeeping. This is your host, Darell Brown. I'm bringing you bookkeeping tips and tricks to make your project finances run a little smoother. Thank you for joining me for the last podcast of October. Our next episode will be on November 5th. So this is the month of October, which officially begins the fourth quarter of the financial year. This is when most companies are reviewing the first three quarters of the year, seeing what went right, what went wrong in planning for next year.
I want to introduce today's topic by reading a quote from Matshona Dhliwayo, author of The Art of Winning. "Small steps add up to complete big journeys." I'll say that again. "Small steps add up to complete big journeys." The author is a known philosopher as well and discusses strategies for winning in life. And of course, one part of winning in life is winning in your business. I like the idea of small steps adding up when we talk about business finances, wherein the fourth quarter when most businesses are starting to plan their 2020 budgets. And it can be overwhelming to have to think about your income sources, what projects you'll have, and the expenses that may be associated with those projects over the next 12 months.
And I often hear, "We aren't able to accurately predict our income and as a result, we can't budget and we don't use budgets." I have two budgeting methods for situations like this. I'm going to introduce the first method by playing a clip from my interview with Sara Roach-Lewis from the October 9th episode of the ProProject Podcast.
Sara Roach-Lewis:
I worked in the not-for-profit sector and a project-based organization. So what that means is you have an idea, you pitch that to a funder, they say, "Yeah, send us a proposal." So you write a proposal and there's a budget attached to it. You get funded and then you execute on what the outcomes are and they give you X number of dollars and that's all you have to do that project. So that was probably one of the more interesting things for me when I started working with businesses. So I lived and died by my budgets. I knew the budgets for every single project that I had in my organization. I knew what my overall budget was. I could pretty much tell you the line items for the money that we had in our organization.
And then when I went and started working for... Those first few clients that I had, and I'd say, "So what's your budget?" And they would look at me blankly. And it's a really interesting gap I think in entrepreneurship is an understanding of how important the budgeting process is and really being able to look at what are the potential revenues and what are the potential expenses to any given initiative that you want to implement in your business. So again, that's [inaudible 00:03:30] in that strategy.
So I look at the strategy, so we decide what is it that we're going to focus on? Then there's that all critical planning part. And part of planning needs to include budgeting. And depending on the business, again, I often work with service-based businesses and there can be a fair bit of ebb and flow in businesses, so that may it easy to say, "Well, I can't really budget." Well, my argument is always, "Actually yes, you can." And then we just create a waterfall forecast and you just look at what are your variances every single month we should be measuring against our annual operating budget?
Darell Brown:
Waterfall forecasting, or waterfall budgeting, it's very similar where you are using that traditional methodology, where you are going to create a 12-month budget, but this method offers you much more flexibility in looking at the document, reviewing the document, and making changes going forward. When most people think of budgeting, they think of it as a rigid document that never changes. By January or maybe February, if your actual net income numbers are lower than your budgeted numbers, you abandon the document and don't look at it for the rest of the year.
And at that point, you're pretty much flying blind. Budget should really be thought of as living, breathing documents. If your numbers in January and February are low, go back to your budget to learn why. What assumptions did you make about your income and expenses when you created the budget in the first place? You could have been courting new business that didn't work out or came in at a lower number. Maybe some of your vendors have raised their prices and you didn't factor this into your budget initially. Or fixed costs. Did your rent go up in the new year? Or are there any other fixed costs that go up annually that you just maybe didn't budget for at the time?
So you review your assumptions and you take all of these factors and you perform variance analysis on your January and February numbers. So variance analysis is comparing the budgeted numbers to the actual numbers. So once you do this analysis, you use this information to revise your annual budget going forward. So now you create a revised budget for March through December. And then once March's actual numbers are in, you review the budget again. How did March perform? You view it against the budget. You review your assumptions again, and you take that and you revise the budget for April through December, and you keep doing this until you are able to accurately budget. All right. So that in a nutshell is the waterfall budgeting methodology. And I'm applying that against the traditional methodology of a 12 month period. There are some that do use the waterfall methodology against a six month period or a three month period.
Or there are some that even use that against a monthly period and they'll break the periods into weeks and then do variance analysis that way. But for some companies, especially if you're a startup, this is still considered to be too rigid of a process. They may need information on a more constant basis, or they just may need more flexibility to make decisions. So the next method I want to discuss is the lean budgeting method. With this method, instead of annual budgets, you budget in sprints, you budget for a quarter. And once the quarter is up, you still do your analysis and you use it to plan for the next quarter. This method usually has more analysis, tends to be more participatory across the company, but costs definitely tend to be scrutinized closely. I find that startups use this method more so because they're trying to control their cost.
And also, that project based companies tend to use this method as well. It's actually a natural segue for what they used to plan their project budgets. So with this method, if you're planning on a quarterly basis, you already have a better sense of the projects and your sales pipeline. So you have a better idea of what the actual gross income is going to be and the associated with that. And then when you're planning your lean budget, you take into account the other fixed cost across the company that go into that. At the end of the quarter, you still analyze your budget, you still do the variance analysis. So you still examine the actual numbers against the budgeted numbers. But in the lean method, the expectation is there shouldn't be major variances from the budget.
If there were major variances, it may mean a project went over budget or the costs weren't estimated correctly in the first place. This strategy helps you to determine why and correct this for the next quarterly period. The idea of the lean budgeting method is to create growth and value to the company and to clients while keeping the overhead low. The argument against this method is that it doesn't give you the insight into overall company planning that an annual budget does. Even though it's meant to offer flexibility, it's a budget that's pretty much set in stone once you create it. So once you lock into three-month budget, the idea is that you have a better sense of what your actual numbers are going be at the end of the period. Any additional expenses that you did not plan or budget for can have serious consequences on the company.
So I actually prefer using a combination of the two methods. I like the idea of the waterfall method because I like to be able to what a company looks like in the long term. And as I'm doing their bookkeeping, I can actually call out issues that I might see that might not be going along with that long-term plan. And I can also suggest strategies for better bookkeeping as a result of seeing this. With the lean method, I prefer to apply that more so to cash flow forecasting. With most companies, I'll have a sense of cash flow for the next month, or two months, or the next quarter. And depending on the contracts that they have out, I can see what the cost should be as well as the income that's coming in and I can make sure to who account for that in the system. So for the most part, I can get an accurate cash flow forecast using the lean methodology and use that to better inform the client ahead of time if there are expenses that are outside of the norm.
And some companies actually shift methodologies. Some companies may start when they're a startup by using the lean methodology. It helps them to keep costs low as they're building and growing. But once they grow to a significant size, they'll switch to the waterfall and use more of an annualized budgeting method to account for their growth into plan going forward. To summarize the waterfall method, it's more based on that traditional 12-month view of the company but offers you more flexibility to look at your actual numbers against your budgeted numbers on a month to month and make changes going forward. The lean budgeting method gives you more of a limited view based on a few months or a quarter. But the idea is that these numbers will be more accurate since you actually have the actual sales data that you need and cost data that you need to plan the budget.
And the variances on this budgeting method should be fairly low at the end of each quarter. I know most of you will be starting to create your budgets in the next couple of weeks. If you haven't started already, I definitely hope that you consider these two methods and that I have made the budgeting process a little less scary for you. As always, if you have any questions or if you just like what you heard, please shoot us a message at info@proprojectbooks.com. That's info@proprojectbooks.com. This is Darell Brown signing off. Please join us for our next podcast on November 6th. That's Wednesday, November 6th. Happy budgeting and Happy Halloween.