Most successful managers know that you can’t make fiscally sound decisions without checking the numbers. In an effort to help managers make wise decisions, companies put a budget in place and check it against the numbers. If you have the numbers and the budget, you might be tempted to think you have all the information you need.
What many people fail to understand is that there are different ways of finding and tracking the numbers in your company. Therefore, there are also different types of budgets at your disposal, which will help you accomplish different objectives based on how you use them. Adopting a dynamic outlook toward your budgets will give a more accurate view of your numbers and a more versatile approach to your decisions.
On today’s episode we’ll share five types of budgets and explain how you can use them to understand what’s happening in your company. These include:
- Static Budget
- Zero-based budget
- Rolling Budget
- Incremental Budget
- Flex Budget
If you’re looking for more tools to help you understand your numbers, then this is one episode you won’t want to miss!
Transcription of This Episode
The Gross Profit Podcast is your one-stop shop on the path to profitability. Each week we share authentic advice on the positive practical steps you can take to make the company you love more profitable. If you’re looking for a positive plan to help you avoid common spending mistakes, control costs, and increase your profits, then this is the place for you.
I’m Ryan Cowden and this week we’re joined by James Kennedy and Garret Carragher. In this episode of The Gross Profit Podcast, James and Garret discuss five types of budgets you can use to take control of your company’s finances. Most successful managers know that you can’t make fiscally sound decisions without checking the numbers. In an effort to help managers make wise decisions, companies put a budget in place and check it against the numbers. If you have the numbers in the budget, you might be tempted to think that you have all the information you need. What many people fail to understand is that there are different ways of finding and tracking the numbers in your company. Therefore, there are also different types of budgets at your disposal, which will help you accomplish different objectives based on how you use them. Adopting a dynamic outlook towards your budgets will give you a more accurate view of the numbers and a more versatile approach to your decisions.
On today’s episode, we’ll share five types of budgets and explain how you can use each of them to understand what’s happening in your company. These include the static budget, also known as the top-down budget. This is a quick budget that allows you to set goals across your company. Next we’ll discuss the zero-based budget. This one is also known as the bottom-up budget and it gives you a clearer picture of where money is going in your company. Then we’ll go over the rolling budget, which helps you set goals on a more timely basis. After that, we’ll talk about the incremental budget. That’s a goal-setting budget, which helps you clearly define the targets you want your company to hit. And finally we’ll talk about the flex budget, which allows the sales team to define growth based on what they are observing.
We’ll also share some advice on how you can use multiple budgets at once to create a well-rounded financial strategy. If you’re looking for more tools to help you understand your numbers, then this is one episode you won’t want to miss. There’s a lot of actionable advice in this episode, so grab something to write with because you’re going to want to take notes. As always, I’ll be back on the other side to wrap up any loose ends. So without any further ado, here’s our conversation with James and Garret.
Hello and welcome back to The Gross Profit Podcast. It’s James Kennedy here, CEO at www.procurementexpress.com where we help hundreds of companies safely spend billions of dollars each year. And I am, again, joined by the secret CFO and Garret Carragher. Garret, how are you this morning?
Great James. All good on my side and looking forward to a really good podcast today on budgeting. So exciting. I know people might not think that, but it really is the way to control your business. What kind of experiences have you had on budgeting, James?
Well, I’m glad you’re well, but I am not well. I am so annoyed. Last month I thought it was going to be a great month. Everyone was humming, sales team were bringing in the sales, everything was looking good. Then at the end of the month I get my accounts in, we get our accounts in about the 10th of each month, which is pretty good. Well, what do you know? We made a big loss. I wasn’t expecting it. It just came out of nowhere and I was livid. I hate it when that happens. So I asked the accountant, “Well, why did we make a loss?” And he said, “Well, you spent the money.” I says, “I know, but why didn’t you tell us earlier we were losing money?” And he said, “Well, that’s not my job. You should have a budget.”
So here we are talking about budgeting as a way of avoiding nasty surprises and keeping a better, tighter rein on spend. So why would you use budgets? Because I’ve heard this before, talked about using budgets, but I’ve never really felt the pain of having a bad month like that, and then realizing I wish I knew earlier. So I’m here to get religion on budgeting, how to do it well, the different types you can do, and how to execute it well. So, you’re my go-to resource, Garret.
No, bother James. Yeah, budgeting is super useful and super kind of extensive where the minor stuff is the cohorts. So I think we’d probably do this over a couple of podcasts actually. So in the first one here, what I’d like to cover off if we think about the different types of budgets and also then how to do a successful budget, which can be difficult. It can really catch you out as it’s caught me out previously. So when you think about a budget, what is the purpose of a budget? When your management team were looking at the accounts and they were thinking like… you were looking at your numbers and you’re thinking, “This really hasn’t hit what I thought it was going to hit. I’ve made a loss this month.”
The whole point then is what you need to do is compare that number back to your budget. Because if you take a simple example, just your sales. If I said your sales in a month were 100,000 or maybe 500,000 or maybe a million. Is that good or bad? You don’t know. You just don’t know. You have to put a context on it. And the way to put a context on it is to compare it to a budget. So then if I say, “Your sales were 500,000, but your budgeted sales for the month were 400,000,” well, then you can say, “Wow, we’re up 100,000. That’s fantastic. That’s been a great month for the company. Well done everyone.” Everyone handshakes all around, great job. But if I say to you, “Okay, actually, you sold a sale. That same sale’s number of 500,000 but I say your budget was actually a million,” then you go, “Oh no, this can’t be. It’s going to close. We’re going nowhere. Our growth is not happening. We’re in fact, going down 50% on our budget. This is a total disaster.”
You said the first thing there that is counter-intuitive for me, which is that actually a budget can be a target. Like a sales target. What you’re going to bring in, not necessarily what you’re going to send out, what you’re going to spend.
Yeah, exactly. So what most companies, or what I’ve used budgets for previously really is to use them as a target for managers. So it’s really a way for finance and for the MD to understand how each part of the business is doing and then really follow up the data and issue new targets or to take actions. That’s what it’s really all about. That’s what all these number’s about. That’s what it’s all about. We’re not doing these numbers or endless spreadsheets for the fun, even though they are a lot of fun. I know you know that, James. But in fact we are doing them to drive a business in a certain direction and the direction usually you want to drive a businesses is to make more money. And what we do is we use our numbers to give us guidance on what’s going on and then that will help us to take corrective actions.
Okay. Let’s go back to school here and just go over the different types of budget you might consider standing up.
Yeah. So if we think about the different types of budgets we can think… there’s really four real types of budgets and then another way to adjust the budget. So usually the first budgets, most people will look at and I’m sure you done this for yourself, James, is you think about a top-down budget or a static project. So what is that? Well, that’s really, you come in as the MD of your business and you say, “Last year we did 10 million in revenue and next year we’re going to do 12 million.” So you really just kind of pull that number out of the air. And your account come in and he sees the top-down budget, you say, “We’re going to do 12 million. Work out the cost on everything else based on that number.”
So that can happen in a lot of businesses. And it’s usually the first way a business comes up with a number is the MD will go out, he might do some research, he might look around the market, but really he’s kind of coming up with a number, which he thinks is achievable based on his knowledge and experience and maybe discussing with other industry professionals. And he will have a look at that.
So startup projects, are they the best type or are they the worst type, or are they just what’s easiest? And what’s the advantage or disadvantage with them?
Obviously disadvantages are that it’s very quick to do and it can be quick to work out the numbers. There’s a lot of disadvantages in that, where has this number come from? What’s the backup? How do you make people accountable for that number. So that can be really tricky to do. So usually what you might start off is that management or if you’re in a multinational, this used to happen a lot to me, head office will come in from a different country and they would basically say, “The market is, our investors want a growth of 10%. For us to get growth of 10% you need to hit 12 and a half percent of growth. For you to hit 12 and a half percent of growth, this is the sales you need to hit based on your last year’s number on your profit margin.” And to be able to work that out, they’ll send you out a request and then you actually work it back to that number. That is the truth. Believe it or not. And even though it might even be based on reality, that can happen quite easily. But even smaller businesses, people would just say, “Here’s our top-down number, work this out,” blah blah blah, and off you go.
So that’s the first way to do it. Now that happens a lot, and I’ve even done that recently in my own business from working and it’s fine, but what you really need to do then if you have the time and you really should do it is a bottom-up budget to match your top-downs. Your bottom-up budget really is like zero-based budgeting. So what that means is you start off with a blank piece of paper or in our case a beautiful spreadsheets and you decide what are we going to work out from here? How many people do we have, what’s their salaries, what’s their utilization, basically? How many hours can they work in a month or a year and what can they sell? What’s the charging rate?
How much am I billing them out at? Or if you’re selling products, you work it out. So that’s all based on a service company. Say you have a company and you’re selling products, you say, “How many products can I sell a month? What’s the revenue in each of those products?” And work it out that way.
So we went over the charge at rate in a previous podcast and maybe listeners can have a look back at that to see exactly… When did we talk about that, Garret? That was in relation to… Oh, we had a listener questionnaire. It’s that right? You were trying to figure out why am not making a profit, even though my turnover is increasing, my profit isn’t. So listeners, back to that for a bit more detail on the charge at rate.
Okay. So you can do a zero-based budgeting. So I guess that sounds like it’s a lot more work. Well, a bit more work, I guess. It depends on the size of the business. But I guess work involved might be, because you don’t really know… I mean it can be hard to, with a blank sheet of paper, remember all the costs in the business and get it right. Right?
Well, you say that James, but you really do need to get it right. You know what I mean? When I’ve gone through the numbers in my business, I go into payroll, I get everyone’s salary. I go and see who’s on a pension. I see who’s got a car. I get the exact number for the car for the year by month. I go then and I look at the products we’re selling, how much is it costing, what’s a markup on every product and then what can a product be, what’s our product mix for the year? So how much of each product are we likely to sell in a new year? I look at our subcontractors. Who are we bringing in, what’s our markup on the price we’re selling those people out at.
And really, you have to go into that level of detail to understand your business. Otherwise, if you stay too much at the top, what happens is you get a number and it says, you made sales of 500,000 and your budget was 400, but you don’t really know where the other hundred has come from.
So you’re kind of looking at it and you’re kind of going, “Okay, we’ve made it.” This looks good on the face of it bought, but do you know why it came out on it? Not really. No, no. I don’t know. We made more sales of this particular item but was that based on the budget? I don’t know. The budget just says 400. So you really need to delve into the deeper detail and that’s what zero-based budget invites. It is a lot more work, but it is the right way to go and it really does validate the top down.
Even in my own experience, I got a top-down number from a particular part of the business and it was going to be, I think it was around 3 million and I knew we… I stuck in all the employees that worked in that department. I stuck in their charge at rates to utilization and guess what? It didn’t come to 3 million. It came to 2.6 million. I think it was 2.7 million, around that. And actually it was impossible for the department to hit that revenue number with the people they had and the charge at rate they were charging. So you can imagine you were already… every month you would have been down, every month. And they’d be saying, “Why are we down? Why are we down? Don’t understand,” blah, blah, blah.
So on the budget, I immediately was able to prove that we couldn’t hit the number. And in fact what needed to happen was they needed to hire three more people and charge them out and then suddenly they could hit the three million target based on, basically, having the correct number of people there.
So the ladder was up against the wrong wall in the first place, basically. No chance to ever got there and I guess if you hadn’t done that exercise, people could’ve pulled it away for a year, missed the target, felt bad about the whole thing, but meanwhile there was zero chance it was ever going to happen in the first place.
That’s exactly it. It becomes a waste of time then because people will look at the number and they won’t understand what the difference is and unless you can explain to them as a management accountant, everyone’s just kind of looking at it and no one really understands. And it just goes from month to month. Every month you’re down 60 grand or whatever it is and no one’s really getting to the bottom of it or no one really understands. And that’s not really what it’s all about. It’s really all about giving useful information to the business, to the managers to allow them to make decisions that will drive the business forward to make more profit. And that’s what our podcast is about as well, James. So it’s all about getting information that is valuable and you can use that to move your business forward. So that’s the first two.
The next one then is a lot of businesses, bigger businesses might do this, which is called a rolling budget. So a rolling budget then is where you’ve done your budget for the year, but you keep rolling it forward one month. So usually someone would do a 12-month budget, so say January to December, but then what a rolling budget is, once we’re in February, they we’ll do another budget for the month of January for the following year. So you still have 12 months ahead of you, instead of 12-month budget all the time. Does that make sense? So you keep rolling it forward. So every time you’ve done a month, someone goes to the end of the budget and adds on another month based on how it’s looked for the last 12 months out. Or the last, sorry, from the last months’ actual figures.
So what’s the benefit in that? Because a month, a year away, it’s quite far away. When might it be good to do that sort of… do it month by month rather than doing it once a year?
So the benefit of that is you can always kind of see where the business is going on a much longer timescale because people tend to think if you take in your 12 months period, then you think about, say 2019, you’re only thinking about… if you have a budget to the end of December, people are only really thinking to the end of December. Who is thinking about January, February, March, next year the first quarter, the next year on the targets you want to hit for that year and how that’s going to look? Maybe you need new employees to hit those targets. Maybe you’re supposed to hiring people at this stage. Maybe you’re supposed to be caught in cost and negotiating a lower price to buy your raw materials that and no one’s looking at that kind of stuff. They’re just looking to the end of the year to December when they get their big fat, juicy bonus as you get every year, James. And that’s all they’re really thinking about.
So it really gives people a much longer view and you can see that in businesses. Some businesses are very myopic, they really can only see short term. We think about the banks in Ireland who sold stuff and got huge commission and then disappeared. If they had a rolling budget and they had to look at it much forwarder and say, “Well, that’s your bonus and different things are going to be based and going for a much longer period of time,” that would’ve really made them think twice about just selling this stuff and really ripping off people.
But anyway, I’m not getting onto that topic. Let’s move on. So we have static, which is top-down. We have our zero-based budgeting, is bottom-up. We have a rolling budget we just discussed. And now we have an incremental budget. A lot of people would do the incremental budget and an incremental budget is basically where you take last year’s number and you add on a particular percentage. Okay? So that in this case… and this is quite an easy one to do. But I don’t know, it’s just huge value. But it can give some value.
But an incremental budgets is if you do a lot of work on last year’s budget, say you did a zero-based budgeting, and you went into every number and followed everything up and understand every cost and every sales and everything, every part of your revenue. So then you might say, “Well, you know what? I think we’re going to increase it by 5% for next year.” So really across the board you say, “Right, revenue’s going to go up 5%, our costs are going to go up roughly four or 5% as well. So just increase everything by that percentage and roll that out for the next year.” And off you go and you’re on your merry way. So that can be quite a useful way as well of doing a budget to get a quick one done, quick budget done. It might even give you help with a top-down analysis to say, “What happens if we increase everything by 5% for next year? How would that look?”
Okay, so that’s very much more a target, builds a parachute on the way down type of thing. You figure out, it’s just a gut feel. I mean some of this is like gut feel. I suppose all of this budgeting at the end of the day is designed to influence human behavior. Right? It’s all a bit of a mind game in a way in that your, let’s say five or 10% growth is just agreed on as a target and everyone trying to hit. And then it comes down to actually how people spend money and what they do and how many phone calls they make. They would then look at their customers at the end of the day, and that’s just a kind of a… it’s a tool. Dare I say it, a manipulation tool. No. Or a way of getting the team together and focusing on our growth.
That’s true actually. But it’s also a way… I think it’s very important to remember that what gets measured gets done. And once you start measuring these things you find you start hitting them. And I know that sounds a bit odd, but it’s 100% true. I always say, if you don’t have a plan, someone else would give you a plan. And it’s important for you to have a plan and anyone out there have a plan for their business and understand where their business is going, where to see the business in a one, three or five years and drive towards that plan. Really drive towards it. And if you do that you can actually hit it. Whereas, if you have more of a… I don’t know. I don’t want to use the word Mickey Mouse, but if you don’t have like a focus, a direct focus and you’re just kind of taking it from year to year to see how it goes, you’re probably not going to be able to drive the business forward as you like.
And what a budget does then is a budget helps people to understand where they’re going and how to drive, what needs to change to make you hit the numbers. So you set an ambitious target. You set your target, you say, “I need to hit this profit number or revenue,” it’s all about the profit at the end, “which should give me a certain profit.” And then based on that you do up your budget and then based on that you make sure your company follows that budget. And of course stuff might happen, big things, but usually you can go along that route. So, is that okay?
Yeah, that’s good. That’s good. So I got that. So what’s the final type of budgets we were looking at today then?
Yeah, the final one then in our part one of our series on budgeting is on a flex budget. So I think it’s quite like… and this is a bit like you just said there, James, about mind games and manipulating people. And really it’s very useful for sales team. So really I’ve seen that a lot with sales where we might do up our budget and we will say, “Okay, what would we be happy with?” So we’ll say, “Okay, we’re happy with 10% growth in revenue.” Okay? So that all sounds good. Happy days, let’s go with that. But what you do then is you go to your sales team and instead of giving them 10% growth in revenue, you say, “Well, actually your budget is to hit 20% growth.” Okay? And you go to your purchasing team and you say, “Instead of you only letting costs increase by 8%, we want you to only have costs increase by 4% or even lower.” Or, “We want you to get a decrease in costs.” Which happens in a lot of businesses. This is very hard to do, but there you go.
And that really is a flex budget. So then you work out a separate budget based on that. So separate budget is your flex budget. So your budget might say, okay, things increase by 10% in revenue and a decrease or increase in costs of 8%. And then our flex budget says a 20% increase in revenue and an increase in costs of only 4%. So by looking at those, you can kind of see what your profit number could be.
So it seems to be that you can mix and match these. You could do a rolling zero-based budget or a static incremental budget. Could you? They don’t just have to be to one type, right?
Don’t have to be one type, no. I think a lot of people, you might end up doing a top-down to get your number from your senior managers. You then as an accountant would work out a bottom-up to make sure it makes sense and that the numbers are valid. Then you might say, “As a finance team, we want to do a rolling budget so that we can see where we’re going to end up in 12 months at all the time. We always have that visibility.” And then incremental is probably a separate one from them. You could do an incremental but you might leave that separate. And finally then you would do a flex budget, which is give a different budget to different parts of your team to incentivize them to hit higher than the actual target you want to hit, than the actual budget you want to hit.
That’s a great summary there. Thanks very much Garret and I hope you guys found that useful. I did. We’re going to follow up with a part two next week, which is all about implementing this budget. We’re getting down and dirty with how to successfully navigate the politics within our organization and getting your budget adopted and deployed successfully. So that’s going to be good stuff. Garret, you’re a star. Thanks very much for your help.
No worries. Great to talk to you, James. Take it easy.
And as always, our listeners can, and I’d encourage you, if you’re looking for more advice on improving profits and controlling costs, go to book.www.procurementexpress.com where our book is being launched. Garret, congratulations, we finally finished it. It’s at the printers and maybe we should give away a free copy. If someone wants to email, [email protected] send me an email, just book and the title and your address, I’ll put one in the post for you.
Great. Okay. See you again next week. Bye.
All right, folks. There you have it. That wraps up our conversation with James and Garret. They shared a ton of valuable insights and advice today on five types of budgets and how they can benefit your company. We also shared some tools and resources, which will all be linked up in the show notes. Don’t forget to click on one of those links to get a free chapter from the book Profit Leaks by James Kennedy and Garret Carragher. I hope you enjoyed our conversation. Please consider subscribing, sharing with a friend or leaving us a review in your favorite podcast directory. Until next time, best of luck in all that you do and we’ll look forward to seeing you on the next episode of Gross Profit Podcast.