With all the media attention on spending and revenue in the U.S. budget, it’s easy to forget that most of us already know how a budget is supposed to work. It is intended to be an outline of how you afford the necessities of life or a business, and still buy some of the nice-but-not-necessary things.
Unfortunately, the government doesn’t set a good example—not having made a decent budget for two years, and not having lived within one for more than two decades. But people and businesses that operate on a calendar/fiscal year are coming up on the start of the budget cycle soon. It’s not a bad time to re-do your home budget, too.
Thus, this is a good time to review time-tested principles that help at budget time. While I can’t cover this large issue in a brief post, here are some ways to analyze expenses and manage the budget process for better results.
Understand the leverage points
- Sales revenue and profit margin increases yield the biggest impact, but are hardest to predict and control. The competitive market gets in the fray.
- Purchased material costs are usually the second largest line-item in most companies, so look for ways to reduce costs through better, tougher and more insightful purchasing. These cost savings drop to the bottom line directly.
- Selling, general and administrative expenses (SG&A), or “Overhead” expenses in the Cost-Of-Goods-Sold are usually the next largest categories.
- Direct labor usually falls about fifth or sixth on the list even though many people focus on it relentlessly—there are usually bigger savings available elsewhere.
Look for the biggest “fixed” dollars to address
- Sort budget items in descending order of annual dollar value and then work on the top of the list first and hardest. To make a meaningful change, it is necessary to work with big dollar items.
- Sort items by whether they are “fixed” or “variable” in nature. Really go after the “fixed” expenses, because these are the ones that kill profits if there are market downturns or shortfalls in expected sales. Fixed expenses are often driven by infrequent policy decisions and once locked in, can be difficult or impossible to change during the year.
- Compare how fixed expenses have changed as a percent of net sales from the prior years to reveal where more fixed costs are being added than sales growth can support.
Study variable expenses in terms of dollars per unit or percentage of sales
Usually, variable expenses aren't exactly variable, but they should be considered as if they were. This means analyzing them based on dollars per unit—if you have a single product line business—or as a percentage of net sales. Then lock that percentage in as the budget and measure against it (instead of a fixed annual budget in dollars). When sales and production go up or down, these budgets will (or should) move with them.
Use zero base budgets for the small (and large) accounts
Review the accounts payable ledger entries to see what was actually spent on the small accounts and itemize the needs—don’t just go for an “inflation factor.” Don’t just accept that inflation in prices is inevitable, and second, that budget line should be a sitting duck for a wise budget cutter if it has not been managed properly.
Tie budgets to specific plans, actions and results
The way to make sound budgets is to work from the strategic plan down through the execution—tactical and operating plans—and then tie budget amounts needed directly to goals and expected results to be achieved. Thus, if a given project, activity or head-count is critical to the success of the plan, the budgeted resources to support it must be there—and should be easier to defend than arbitrary percentage increases based on some assumed inflation factor.
Make a contingency plan before a crisis hits
Identify the contingency items that can and should be cut (or postponed) if the top line sales don’t come through. Better to identify them now, when there isn't the pressure of an actual crisis, than succumb to the knee-jerk reaction of “cut everything.” (Which is usually exactly the wrong thing to do.) If you plan ahead where you can cut in downturn, it’s a lot easier to make those cuts quickly when things get tough.
No doubt about it, budget time is a period of intense competition for scarce resources—not only money, but also people and time. Those who do their homework will not only get the resources they need, but are a lot less likely to get saddled with unrealistic budgets.
Believe me, it’s better to be thorough, well-prepared and tough-minded once a year than to suffer the pain 12 times thereafter—at each monthly budget review. If you last that long...