Preparing to Lead: Understanding Budgets and What Makes Your Company Profitable (Part 1 of 2)

A budget is telling your money where to go instead of wondering where it went. — Dave Ramsey

Understanding Budgets

Companies run on numbers: profits, losses, expenses—all of those (and more) form the structure of any organization and shape its success or failure. Financial considerations are so critical that companies have entire departments and even C-suite positions (CFO, anyone?) dedicated to gathering and analyzing financial data, understanding budgets and determining profitability (just to name a few).

Finance folks have special skill sets and knowledge that make them well suited for number crunching. But even if you aren’t a finance type yourself, you still need a good understanding of how the numbers work as it’s required knowledge as you move up in at organization. After all, understanding budgets helps determine what resources you have (such as employee salaries, training, supplies) and is shaped in part by how effective (in terms of profits and losses) you are at using those resources.

If your company’s fiscal year coincides with the calendar year, you’re probably neck deep in budgeting discussions as we speak. And because your budget plays such a huge role in the success of your team, department, or organization, I wanted to provide some insights into how the numbers work—especially if they aren’t your specialty. So, let’s take it from the top.

 

First, Learn the Vocabulary

Don’t ever let your business get ahead of the financial side of your business. Accounting, accounting, accounting. Know your numbers.

—Tilman J. Fertitta

Before you can do anything with your numbers, you must understand a few fundamental accounting principles, because they set the stage for the preparation of a budget. Even if you aren’t a finance specialist, I’m sure you have some familiarity with what I like to call the Queen Mother of All Accounting Equations:

assets = liabilities + equity

Assets are what the company owns. Liabilities are what the company owes. Equity is the difference between assets and liabilities. Simply put, equity is what the company has left over after the bills have been paid. This equation

An organization has two additional types of accounts: revenues and expenses. Revenues are what the organization earns for selling its products and services, from its investments, and for selling its assets. Expenses are the costs the organization incurs to run the business. The difference between revenues and expenses—that is, the organization’s profit or loss—goes into the equity of the business.

Understanding BudgetsIf you’ve ever worked with budgets, you’ve probably encountered the term generally accepted accounting principles (GAAP). The U.S. Securities and Exchange Commission defines them as “accounting standards, conventions, and rules. It is what companies use to measure their financial results. These results include net income as well as how companies record assets and liabilities.”

Organizations are not legally required to adhere to GAAP, but most do so nonetheless because it allows a wide variety of organizations to report their finances in the same way. If an organization’s financial statements are audited by an outside accounting firm, the auditors are required to disclose all deviations from GAAP. Because such deviations can jeopardize a firm’s financial credibility, most organizations choose to comply with GAAP.

To conform to GAAP, a business must use accrual-based accounting (rather than cash-based accounting), which recognizes revenues when they are earned (or invoiced) instead of when they are received. At the same time, expenses are “matched” to the time period when the services are used up—and not to when the invoice is paid (the expense should be accrued in the month you received the service). This “matching principle” applies regardless of when cash changes hands!

Accrual accounting allows organizations to determine their profits more accurately, because it factors in the fact that expenses are often paid in a different time period from when revenues are collected. Accrual accounting does not measure the cash flow of a business; rather, the statement of cash flow does this measurement and therefore is as important as accounting profit detailed in the income statement.

 

Let’s Crunch Some Numbers

Manage your spending by creating and sticking to a budget.

—Alexa Von Tobel

Once you understand basic budgeting concepts such as revenue, expenses, GAAP, and accrual accounting, you can start putting numbers on paper.

Understanding BudgetsThe chart to the right illustrates the master budget structure of a typical company. Companies usually set sales projections first, then determine the production costs associated with achieving their sales goals. The administrative expense bucket comprises all the individual overhead departments (HR, legal, finance, facilities, IT, etc.) that are associated with the operation of the company, not with the actual selling or production of the company’s products.

I’ve created the following Excel worksheets (with instructions) for capturing costs as you put together your own operating expense budget. (Note that there are separate versions for for-profit companies and for nonprofit organizations.)

The accrual-based accounting I mentioned earlier comes into play when compiling costs, because you must account for costs in the month you receive a service, regardless of when you actually pay for it. (For example, if you pay $25k per month for workers’ compensation for your employees, your finance department will account for that charge each month regardless of when the invoice for it is paid.) The same principle applies on the revenue side: the revenue exists when you do the work and invoice the client, not when you actually receive the payment (even if it takes 60 days for you to collect the money!).

Understanding BudgetsPrepaid expenses are another example of accrual-based accounting. If you prepay a contract six months in advance, for example, your finance department will book the total paid in a prepaid expense account, then accrue the prorated amount (i.e., the total divided by 6) to your department’s budget each month. When compiling your budget, you merely list the monthly expense. (Chances are your finance team will tell you how they are accounting for prepayments but be sure to ask if you’re in sales!)

This is a unique year for budgeting expenses as almost everything has gone up. Goods, services, labor – you name it and the price has gone up. Labor in particular is reeking havoc on budget projections as companies are resorting to massive salary increases for even the most junior positions in the company to attract potential new hires.

Prior to COVID, I typically tried to allow for no more than a 10% increase from the present year’s budget (unless something major was on the horizon such as moving offices, a merger or acquisition, new product launch, etc.). That rule is pretty much out the window though as inflation has increased the general cost of everyday items. 

Your current budget is obviously the best place to start when compiling your next year’s budget. As part of your budgeting due diligence though, you should interview senior leaders and department heads to identify new initiatives that may affect your budget. (Side note: This is a great way to start – or continue – direct line discussions with the senior leadership of your organization!). 

 

Figuring Out Your ROI

Return on investment (ROI) is a measure of how much benefit or profit can be obtained in exchange for an investment of a resource (usually money, but sometimes effort or time). A desire to figure out “is it worth it for me to put X into this?” applies to most business-related decisions. It even pops up it in other areas—including our personal lives. (“It took me weeks to watch that entire ‘how to knit’ series on YouTube, but my mom really loved the scarf I knitted for her, so I think that’s a pretty good ROI!”) 

That said, ROI calculations—also known as cost–benefit analysis—are most widely applied in the financial world. If you’ve ever been involved in capital expenditure (CapX) budgeting (for large equipment purchases, for example, or for acquisitions or new product development), you’ve almost certainly done some ROI calculations before committing to the expense. 

These calculations involve a concept called the time value of money, whose basic premise is that a dollar today is worth more than a dollar collected tomorrow—which in turn is worth much more than a dollar collected in ten years. (Future money presents a huge challenge because there are risks associated with actually collecting it.) If you’re involved in CapX budgeting, you probably have at your disposal financial tools that calculate ROI and take into consideration the time value of money. (And if you don’t already have one of those tools and need one, I recommend this spreadsheet template, which is pretty comprehensive and not expensive.) 

The ROI calculations for smaller projects that might be included in your operating expenses budget are basically the same as the calculations for CapX budgeting. Because the payback period for smaller projects is typically within the same year, though, the time value of money is not a factor in these calculations. 

As an example, look at the numbers for a project for outsourcing benefits administration. Understanding BudgetsTo calculate ROI for this project, start by determining the total costs and benefits of the initiative. In this example, the costs are $900k, and the benefits (savings) are $1.2 million. The net yearly benefit of $300k equates to $33,333/month in savings to the company. With a $100,000 cost to transition to an outsourced model, the ROI is calculated as $100,000 divided by $33,333, which equals 3. Thus the break-even point (or payback period) is three months, which means the company does not see a financial benefit until month four, because during the first three months it must recoup the $100k investment.

When making decisions about whether to launch (or close down) any project, managers need to look at the numbers. Where are the profits and losses? What are the expenses? How does this project affect other parts of the company? ROI calculations can help leaders see which projects carry the most value—especially in comparison with competing projects.

Bulletproof Your Budget

Once you’ve created a budget, you need to sell it to the C-suite before you can implement it. Triple-checking your numbers and making sure the details are worked out can improve the likelihood that your proposal will gain approval. Pay close attention to the following ten points so you don’t wind up with any holes in your budget.

  • Your budget is a monetary representation of your department’s goals. When you make the connection clear between your spending and achievement of the company’s goals, it’s harder for decision makers to cut your funds without having a negative impact on the company.
  • Return on investment (ROI) calculations illustrate the payback period for individual projects. By comparing ROI to company goals, you can rank and market initiatives according to their impacts on the bottom line.
  • For larger projects under consideration (such as expanding into a new product line), ensure that gains in market share do not consume a disproportionate amount of cash from the company (in the form of more inventory, extended duration of accounts receivable, increased complexity, etc.). This philosophy of cash efficiency should be applied to your current product lines as well. (Always ask yourself, “Where am I getting the biggest bang for my investment dollars?”)
  • For some projects, the value-added proposition is more important than the return on investment. In those cases, highlight how that added value will help the company achieve its goals.
  • Understanding BudgetsAlways prioritize your initiatives—and be prepared to scrap whatever’s at the bottom of your list in order to keep your preferred project in the top spot. When reviewing budgets and thinking about what to put on the chopping block, senior management typically goes after projects with the highest price tags—so do what you can to control how your funds are cut.
  • Find out which cuts to other departments could affect your ability to cut spend in your own budget.
  • If there’s a dollar impact to the company for not implementing a project or if you can push the spend to later in the year when company finances are better, communicate that clearly to executive management.
  • Because companies are worried about cash flow and about having enough credit to weather the downturn in sales, link your spend to how it will improve your company’s profitability.
  • Find others to support and tout your initiatives. (Keep in mind, though, that because everyone is scraping for dollars right now, it can be tough to find other department heads to champion your spend.)
  • Ensure that anyone who has anything to do with finance thoroughly understands your spend so they can defend your budget if you’re not in the room.

And there you have it: budgeting principles in a nutshell! If you’ve been anxious about dealing with financial matters before, I hope you’re now feeling a little more confident about tackling them—because you must tackle them. When it comes to budgeting, when you’re the leader you can’t go into ostrich mode and bury your head in the sand. Because finance issues shape everything that happens in your department and your company, you need to understand how to put together, sell, and implement a budget. 

Tune in to my next post, which will explore the three key financial statements used in business (namely the income statement, balance sheet and statement of cash flows). 

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