Lance Geda | Director of Strategic Finance
Have you ever seen a business with extraordinary, almost unimaginable, profit growth suddenly reverse course and post an operating loss a couple of years later? It happens more often than you might think, and most often, it results from inadequate financial management–beginning with a proper budget.
An operating budget serves three key purposes. It provides a viable framework to plan for next year, it’s an activity that facilitates intentional reflection and growth on the past year, and it lays the foundation for strong company financials.
1. Plan for the Future
The single most useful reason for an operating budget is so that you have a plan for where you are going. When you take a road trip, do you put a blindfold on before you get in the car? Probably not. Before you fill-up the gas tank, you probably have a good idea of where you are going, what you will see, and how long you will be gone. On some level, you’re prepared.
Your annual operating budget is a lot like a roadmap for planning a trip but for your business. It can help plan for costs so that you can focus on where you want to grow. As you start making decisions, your operating budget can provide high-level guidance that helps you determine the right mix of increasing revenue versus increasing efficiency to achieve sustainable growth.
It can also be a catalyst for important conversations that dive into macroeconomic influences like whether or not your business will be susceptible to raw material price increases, wage inflation, foreign exchange rate risk, or if higher interest rates will impact your ability to buy or sell materials.
2. Reflect on the Past Year
When done properly, an annual operating budget provides the perfect opportunity to review spending for the previous year and ask important questions. Use this opportunity to dig into the differences in financial impact between one-time benefits or liabilities and recurring (or typical) conditions.
For example, if your organization received a large, one-off project that doubled revenue in one month, it is unlikely that the following year you can expect that same result from a financial perspective. Understanding when and why these anomalies occur is an important step in truly understanding your profitability and ultimately your cash flow.
When reflecting, look for things like:
- Costs associated with recruiting and hiring staff. Are these typical, budgeted expenses or were there significant variations due to growth that you do not anticipate will recur the following year?
- Missed opportunities due to sales staff missing performance-based targets. Are these typical fluctuations, or are there patterns that can be associated with specific hiring practices or other macroeconomic trends that you would expect to have a favorable impact on next year’s revenue?
- Do you have new recurring revenue that makes it likely that you will start the new year with a higher base than the previous year? If your December monthly recurring revenue is 20% higher than the previous December, it is safe to assume that your revenue for the following January will be up a similar percentage.
3. Roadmap to Achieve Critical Objectives
An annual operating budget sets a good foundation for all of the big goals that you want to achieve. From increasing revenue to maximizing efficiency, every move that you make begins with an understanding of where and why money is currently coming in and where and why it is going out.
For example, your annual operating budget includes a revenue target. In order to meet that target you need to understand all of the inputs, like pipeline management, inventory control, product roadmaps, and employee utilization. If you understand how each input impacts the overall revenue, then you can adjust each input that will collectively increase revenue to hit the target.
For gross margin, your budget includes a target for gross margin that is influenced by factors like unit pricing, employee utilization, raw material costs, inventory management, and shipping costs.
Operating expenses are affected by staffing for sales and marketing, understanding the efficiency of your sales team, the effectiveness of your marketing dollars, and the administration needed to support these functions drive your sales, marketing, general, and administrative costs. Other services required to support your sales and revenue-generating teams, whether that is goods or services, include rent costs, travel and entertainment, insurance, professional and legal fees.
The last piece of the operating expense budget is understanding your costs for research and development. Tying these costs to a product roadmap can help to ensure you are only spending on goods and labor that will help you achieve the product or services on your roadmap and help you eliminate the costs that do not relate. Accurately forecasting these items will require a mix of knowledge of what it cost the prior year, and what type of macroeconomic conditions could affect these costs in the upcoming year.
Your Annual Operating Budget is a Dynamic Tool to Achieve Success
Your annual operating budget is more than a spreadsheet that helps you look prepared. When fully utilized, it’s a tool that can help you reflect and grow, plan for the future, and show you where you need to course correct mid-year to get you back on track.
No company plans to fail, but many fail to plan. Invest more time, energy, and intentionality into the use of your Annual operating budget as a tool to keep you on track for profitability.
Get in touch with the team at Embarc Advisors to learn more about how to create and use an effective operational budget to streamline your success.
