Prologue: Budgeting in a Crisis

We wrote and intended to release the following article about small business budgeting before the spread of COVID-19 became the full-blown crisis that it is today. While we’re all operating amid uncertainty, it’s still important -- perhaps even more important -- to have a financial plan that is realistic, simple, dynamic, logical, and useful, which is why we are still opting to share it.

Given the current reality, a stretch budget isn’t something most businesses would find useful to put together right now, but an austerity budget focused on cash flow is highly relevant.

If you’re a business owner, now is the time to make cash inflow projections on a daily or weekly basis and match them to a list of prioritized cash outflows, updating both in real time. This will allow you to set goals, know what you can pay and what you can’t, and monitor trends in your business.

Better days lie ahead and a plan will help see you through to them.

“Budget,” “Forecast,” “Projection,” “Plan.” Whatever you call it, a strategic and forward-looking financial plan is a must-have for any organization, but it can also be a hassle and an exercise in herding cats. You’re not alone if you mutter, “Budget season sucks,” when Susie from accounting is hassling you about getting your numbers in. 

What’s more, the whole process can become demotivating and inspire cynicism if done poorly. That happens when lots of work is put in up front, but the output bears little resemblance to the ongoing realities of the business and is therefore ignored for the duration of the year only to come up again during the next budget season.

Operators not only want to avoid this scenario, but can also benefit greatly from the clarity that a good financial planning document can provide. How can that be achieved? It begins by understanding the point of such a plan and ways to make sure it stays relevant through the year. 

The point

A budget is primarily a communication device, laying out both the company’s goals and what it plans to invest to achieve them. It follows, then, that a budget’s effectiveness is constrained by how widely it is shared in the organization. This is not to say that everyone in your company needs to know every gory detail of your financials. But the more you are able to share and the more broadly you are able to share it increases the budget’s effectiveness at communicating your expectations, helping employees identify how they might contribute, and holding teams and individuals accountable. If events don’t go to plan, well-informed employees can use a budget to help pinpoint where and why that variance occurred.

To do that, though, a budget requires certain characteristics. A good budget is:

1. Realistic -- achievable outputs based on observable inputs.

2. Simple -- easily explained and understood.

3. Dynamic -- adaptable to changing circumstances.

4. Logical -- derived from measurable variables that build on one another in straightforward ways.

5. Useful -- able to be used by employees in everyday decisions.

How to make it realistic

A realistic budget starts with a purpose based on first principles, which guides how the budgeting work should be done. There are a number of different budget “flavors” and it’s worth spending time to consider which is most appropriate for your business. An annual budget will give you a better sense of how much you can reinvest this year. A stretch budget may motivate your team and incentivize them to outperform prior periods. An austerity budget can set goals for controlling expenses.

The budget’s purpose serves as guardrails for how the budget itself is created. An austerity budget should be built from relatively conservative revenue assumptions based on historical data (more on that later). A stretch budget can be more aggressive on the top line, but expenses shouldn’t keep pace with presumed revenue growth in case it doesn’t materialize.

A realistic budget should also reflect how the business actually operates. You know that one sentence you use over and over to explain to people what you do? Your budget should follow that same logic. It should be built on at least some of the same metrics you use to run your business

Finally, a realistic budget has to be based on historical data. A good budget doesn’t start with the first month or quarter you’re forecasting. Your forecast should be preceded by actual historical data so that your budget is presented in context and is extrapolated from reality -- ideally several years of it. People consuming the budget should be able to see how it got from 2 years ago to last year to this coming year and the year following.

 

How to make it simple

Businesses are messy, with outcomes that are influenced by a multitude of factors. But our experience is that the Pareto Principle applies. This is to say that the vast majority (80% to 90%) of results will be driven by a much smaller percentage (10% to 20%) of variables. 

A good budget identifies these key variables and can be built in no more than 20 rows. In other words, good budgets don’t try to explain everything, nor do they tie every function of the organization together. A good budget focuses on the things that drive the success of the business. 

If you are able to keep a budget on one page, it’s inherently simple. And the benefit of simplicity is that it’s easily explainable, which means not only that it can be communicated to the entire team at something like an all-hands, but also that employees can evangelize the budget to their peers. When an entire organization is able to understand and explain a plan, our experience is that buy-in rates -- and therefore the probability for achievement -- are significantly higher. 

How to make it dynamic

A good budget doesn’t have to be -- and really shouldn’t be -- static. Rather it should be updated regularly as the year unfolds, a process that actualizes it with the entire organization and makes it more and more accurate with time, which can give more clarity to decision-making.

Additionally, if you’ve built it from historical data and kept it simple, incorporating new data should be easy and may allow you to unlock new projects, spending plans, or initiatives if things are going better than expected or pull back if things are going worse.

Either way, the entire organization will be able to understand how and why decisions are being made, which is what anyone whose livelihood depends on an organization wants to know.

How to make it logical

A logical budget starts from the point of greatest certainty. If, for example, you have high amounts of recurring revenue or a reliable backlog of work, it may make sense to build your top line first and then layer in spending plans and growth initiatives. If, on the other hand, you have a sales force that needs to win discrete work, have historically lumpy sales, or feel you may be entering an uncertain economic environment, it’s logical working the other way, starting with the expenses you know you will have and then building the path to the revenue you will need to sustain them.

Whether you work from the top down or bottom up, your revenue projection, the lifeblood of your business, will not come from the sky. In fact, starting with sales or revenue as a dollar figure is cutting out important steps in the way you make money. 

Do you pay for advertising? If so, how much and what is your cost per lead? At what rate do leads turn into paying customers? What percent of your revenue is from upgrades/upsells and is that number going up? Is your eligible customer base growing or shrinking? Identifying and rolling up these contributors to sales help keep us more honest about our revenue projections than simply starting with top line dollars.

That said, to borrow from former Intel CEO Andy Grove, each volume metric you use in your budget should have an accompanying rate metric and vice versa, with logical interplay between the two. After all, conversion rates typically aren’t likely to persist as spending scales and this will help make clear and therefore help you examine key assumptions that may underlie your projections.

Finally, we’ll award bonus points to any budget that is able to build in external data to inform its view and that contemplates a range of outcomes rather than a handful of specific numbers. After all, no budget will be accurate. Knowing that ahead of time and telling your team that you want to be in a neighborhood can be healthier than trying to hit a specific number.

How to make it useful

If you’ve done all of these things with your budget, your team should be able to use it to guide decision-making around investments, spending, pricing, and more and ensure that when confronted with a choice, your key employees are likely to choose the same option you would. This effectively drives leadership down into your organization and helps build a more sustainable and scalable enterprise -- which not coincidentally is a trait that will make your business much more valuable in the eyes of potential buyers. The key is to trust that your budget will do this and see if it’s getting the results over time your intended.

Additionally, a useful budget will also serve to give you a sense of how much you can reinvest in your business and how much you can safely borrow, leading to more efficient capital allocation and investment. If you’re able to reinvest capital in your business in real-time rather than wait to see what’s in your bank account at the end of the year, you’re likely to grow much faster and at more sustainable rates.

That’s the case for a realistic, simple, dynamic, logic, and useful budget and how to build one. While it’s an exercise that has a bad reputation and one we know most small businesses avoid, we also think that done correctly it can be a powerful tool that can help grow the long-term value of any business.