Today’s scope and depth of disruption to companies – especially small- and mid-sized firms – is virtually unprecedented. In this time of the pandemic, most companies will face severe challenges. Operating budgets will come under pressure, particularly when it becomes clear that they are not dynamic enough to provide a useful, adaptable roadmap. So we have looked back at what makes for good budgeting. Herewith our advice in a nutshell.
The annual operating budget is your goalpost for measuring financial success. But is it a help or a hindrance as you respond and re-plan in real-time to the impacts of the coronavirus? The answer often depends on how the budget was prepared and documented, and the management capabilities in place to keep the organization on plan, and adjust the plan.
As management consultants, we work with business leaders and their operations and finance teams to prepare annual operating budgets. We also assist management teams to get back on track or re-plan in response to major disruptions. In this process, we not only uncover opportunities to improve operating performance, but we also often find significant deficiencies in the budgets themselves – adding to the problems or hindering their resolution.
In this Brief we highlight five opportunities for better budgeting, helping managers to build annual budgets, stay on track, and rapidly and accurately re-plan, as the year progresses or as the pandemic-related disruptions necessitate.
Last year’s numbers are relevant, in context
Typically, we find that the prior year’s actual results are a sound and pragmatic base for building a new annual budget – more helpful than adopting a strict zero-based budgeting approach. Many factors driving the business reliably repeat from year to year or can be extrapolated from several years’ results, e.g., sales mix across the company’s product portfolio.
But with many company budgets now in tatters as result of the pandemic, immediate re-budgeting and annual planning for 2021 will necessitate a pivot to a more hybrid approach. In this approach, prior-year factors and trends which are expected to remain in place going forward (“business as usual”) are incorporated into a bottoms-up, zero-based (“it’s a whole new world”) budget buildup.
So, to the extent possible, leverage the most recent and prior years’ financial, productivity, and volumetric data as a basis to launch the annual budgeting process. Seek out and remove one-time events or errors in the data – possibly many pandemic-related impacts. Partial-year effects need to be annualized; for example, if a new cost saving process was implemented mid-year. Be sure that manufacturing standard costs have been updated and new ones accurately engineered for new products. Have new suppliers been brought on board and factored into cost of sales? Did last year’s marketing promotions drive sales to products with higher manufacturing costs or cost of quality? Will these programs be repeated?
It is often helpful to look back at the prior year’s budget variance explanations: which ones must be considered in next year’s budget? Many will be one-time pandemic crisis impacts. Others will be long-lasting and form the new normal. All that work analyzing and explaining your budget hits and misses each month is more than just looking in the mirror, it’s essential to better budgeting going forward.
Straight-line extrapolations may not apply
Simple extrapolations can lead to erroneous expectations when costs or other budget inputs change step-wise rather than linearly with volumes. A 10% top-line revenue increase goal may not equate to the same change in volumes, costs, or capacity utilization. Productivity may drop significantly when overtime or temporary help is deployed to reach the stretch sales targets or meet pandemic-related demand surges. Supplier and customer contracts may have tiered pricing or volume discounts. The relationship between fixed and variable costs may vary considerably across your product line and manufacturing network.
By taking the time to model these kinds of factors comprehensively, there will be fewer surprises and less time scrambling to explain what happened. And when things do change as they now have for many companies in a big way, you will have a better understanding of how they will impact your numbers, your periodic forecast updates and your business plans.
Don’t forget the future
When developing your operating budget, don’t forget to include projects and costs that won’t yield results until the following year or later. Have your long-term strategic initiatives been factored in? Will deferred maintenance expenses or postponed equipment upgrades in prior years create painful surprises in the future? Now might be the time to budget for those costs. Also, be sure to factor in depreciation charges when new IT systems or other initiatives – capitalized in prior years – are scheduled to be put into service.
Dynamically document the inputs and assumptions
As the year progresses, forecasts of anticipated full-year performance vs. the budget are essential to support timely decisions and communications with key stakeholders, whether the expected variances are on the upside or the downside. A dynamically documented operating budget enables more accurate and rapid re-forecasting, a critical need right now.
For many of our small to medium-sized clients, this takes the form of linked worksheets that build up the operating budget. While some factors might be static, others may be more complex functions of demand, costs, capacities and such. For example, budgeting and then accruing for performance-linked employee pay bonuses may involve nonlinear escalators/decelerators that can be dynamically documented in a worksheet rolling up to the total compensation line. In this way, your periodic forecast vs. budget outlooks can be easier to produce and more accurate.
Put in today’s extraordinary context, many companies are finding that their budgets are suddenly obsolete, whether demand is spiking or vanishing, or that costing assumptions have totally changed. Having a dynamically documented budget is extremely helpful to be able to rapidly and accurately incorporate internal and external changes into your revised budget outlooks.
Stress test the budget
Does your organization have the core capabilities to deliver the budgeted results? Increasing the top line may require new sales offices and staff or a successful acquisition integration. Or on-boarding additional co-packers. Or shedding assets in response to the current crisis. Are those plans and costs factored into the annual budget and revised budget outlooks? What’s the lead time to get them in place and ramp up to expected productivity? Is this reflected accurately in the operating budget?
We have seen this kind of rigorous stress testing given only cursory attention. Catching and addressing these mismatches between embedded assumptions and current and projected reality is paramount.
Right now, many companies’ budgets and budgeting processes are being severely stress-tested in real time. Turn this crisis into an opportunity to improve your budgeting. Your budget can do more than serve as a goalpost. Better budgeting leads to more timely actions, improved results, fewer surprises, and more time and resources spent on building your business rather than explaining what happened.
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David Frentzel is a Partner at New Harbor Consultants. Dave brings 30 years of management consulting and hands-on executive leadership experience to improve business outcomes. Prior to joining New Harbor, he held various senior positions at 3PL and supply chain technology companies. Dave has extensive global management expertise having spent more than ten years living and working internationally helping companies with their global go-to-market, organizational, sourcing, manufacturing and supply chain strategies and operations.