The Role of Finance in the Middle-Market
Previously we reviewed how you can structure your strategic budgeting process by translating your business’ goals into specific, measurable and achievable initiatives which allows your departmental leaders to plan ahead and fosters a culture of ownership. This month, we will review different budgeting methodologies that will help you identify and select the right process for your business. Once you have selected your budgeting methodology, it is essential that you implement a technology solution that will enable visibility, centralized governance, and keep you organized as each departmental business leader provides feedback throughout the process.
Selecting the Right Budgeting Methodology Is Critical to Meet your Long-Term Plan
The highest priority budget for most companies is the operating budget. This budget contains revenue and expenses and is broken down into each revenue category or channel, including labor cost, benefits, and non-salary expenses. Once you have this information as the baseline, there are four methodologies you can utilize to build your budgeting process.
- Incremental Budgeting – We see many businesses utilize this method due to its simplicity. This method looks at the previous year’s expenses and adds or subtracts a percentage of the total. While simple to develop and understand, this method does have inefficiencies that can be addressed by some of the more sophisticated methods listed below.
Advantages Disadvantages o The budget is stable and change is gradual
o Managers can operate their departments on a consistent basis
o The system is relatively simple to operate and is not time-consumingo Assumes activities and methods of working will continue in the same way
o No incentive for developing new ideas
o No incentives to reduce costs - Value Proposition Budgeting – This method focuses on making sure that all items included in the budget deliver value and have very specific objectives to drive ROI for the business. This allows unnecessary expenditures to be removed from the budget and business owners can understand how each budget line item is driving towards the bottom line.
Advantages Disadvantages o Identifies and qualifies goals and objectives while holding all departments accountable for the process
o Emphasizes achieving the organization’s goals and objectives and is integrated into the broader strategyo Encourages management to make decisions based solely on their business judgment
o Doesn’t always align expenses with the business activities required to achieve the revenue
o Can lend itself to qualitative debates among senior staff - Activity-based Budgeting – This method is prepared by using activity-based costing after considering the overhead cost. This focuses on reviewing the business as a whole and examining each activity from a cost perspective, bringing a transparency to costs that make it easier to identify additional savings to the business.
Advantages Disadvantages o Links every function and department with their spending and provides a complete picture of the business and clear accountability for expenses
o Takes into account each and every activity that incurs costs which can improve the bottom line
o Identifies any non-value-added activityo Takes a lot of time away for resources to come up with the budget
o Focuses on the tactical goal rather than the long-term strategy
o Not practical for every type of business – only those that can feasibly implement activity-based costing - Zero-based Budgeting – This method assumes all departments start with a zero dollar expense budget and each leader needs to come develop their own budget and defend it based on the services they provide to the business. This bottom-up approach allows business owners to understand how each component of what they do and what they spend money on converts to business value. Due to COVID-19, we have started to see more and more companies taking this approach.
Advantages Disadvantages o Ensures that each department has the exact amount of resources and funds they need
o Helps management strongly understand the trade-offs between expenses and value when any event triggers a mid-year adjustment (e.g. COVID)
o Establishes a strong tie between the way money is spent and the overall strategy
o Allows for the identification and elimination of expenses that don’t add value
o Eliminates arbitrary usage of expense budget amountso Demands more time and attention from management each year
o More difficult to account for strategic investments geared towards innovation
o Creates additional effort when revising forecasts during a budget cycle
Regardless of the budgeting methodology that you select for your business, it is extremely important that you give yourself enough time to develop it prior to the following year (typically 3 to 6 months). In addition, obtaining feedback and realistic inputs from departmental leaders is what will allow you to drive performance and motivation, and get your employees to buy into the plan.
The right technology is necessary to drive excellent planning and budgeting processes
Most companies have experienced siloed and manual processes outside of the system because today’s technology systems do not provide a one-size-fits-all solution that business users are looking for. The reality is that systems feeding into unstructured excel spreadsheets are still often accepted for corporate planning and budgeting processes. Corporate Performance Management (CPM) solutions like Prophix can normalize and monitor data from various sources to create structured models with pre-defined reports, templates, and business logic.
Each one of these budgeting scenarios has the ability to shape the data across different types of accounts, departments, legal entities, and reporting currencies, allowing business users flexibility while improving forecasting accuracy. The right technology will allow business leaders to worry about the business scenarios more than the budgeting process itself.
Some examples include:
- When planning for capital expenditures, most businesses prefer to take a value proposition budgeting method. This means a major investment will require a review on cost, ROI, and timing. Building a standard recurring process for capital requests can be expedited by using a technology solution (e.g. Prophix). Capital request are simply integrated with current forecasts to see their impact on cash flow, profitability, and total spend.
- On the other side, SG&A or expenses might be uniform and should follow a standard template from year-to-year, so the incremental budgeting method is practical. The ability to quickly apply increases or decreases to administrative and overhead costs based on operational drivers (i.e. headcount) can be simple, logic based, and automated on a regular basis using your CPM system instead of disconnected spreadsheets.
Clients who monitor and manage their budgeting process with a technology solution obtain real-time updates through dashboards and reports that provide the level of detail needed to run their operations. Please see the examples of end user dashboards and reports below:
Now that you have a better understanding of different budgeting methods and what the technology can do for you, you will be able to accelerate your budgeting process while driving transparency and accountability.
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Our Rapid Reporting & Analytics Improvements services take 2-4 weeks. At the conclusion of the project, you will have a detailed financial analysis of your company including financial, operating and leverage ratios, comparison of your company’s performance to industry standards, a list of recommendations and a roadmap for execution, and examples of financial reports tailored to your company and its operations.
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