Welcome to Part 3 of our Budgeting Series, where we conclude our exploration of business budgets by outlining how to prepare one. In Part 1 we discussed the fundamental aspects of budgets, and Part 2 discussed why budgets are important. If you missed these articles, be sure to catch up on them.

In this article, we will explore budgeting methodology for business and outline how to take steps to prepare your own budget.

There are two primary methodologies employed when developing a budget:

1. Top-down Budgeting:
   Top-down budgeting involves senior management setting the budget in line with their strategic goals and then passing it down to the line managers. This method is faster but can lack appropriate grounding if senior management is not closely involved in the operations of the business. This is the method typically utilised by small to medium businesses that don’t have multiple business units or divisions.
2. Bottom-up Budgeting:
   Bottom-up Budgeting involves line managers preparing budgets for their areas and then passing them up for senior managers to review and approve. This method takes longer to collate and can result in the budget being padded if line managers want to make staying on budget easier. This method is typically utilised by medium to large businesses or those that have multiple business units or divisions.

 

A hybrid of both methods can be used to produce a more collaborative budget, however, finalising a hybrid budget generally takes longer.

 

Budgeting process

Once the methodology has been decided, it’s time to choose the process for drawing up the budget. There are two possible options:

1. Incremental or Quick Budgeting:
   Incremental budgeting is a process whereby the previous budget or historical figures are adopted with nominal adjustments for future positive or negative growth. This method is quicker and simpler but can lead to inefficiencies being built into the budget or the budget not being robust enough to encompass the business’s strategic goals.
2. Zero-Based or Clean Budgeting:
   Zero-based budgeting involves creating a new each year based on underlying business policies or analysis. This process is slower but develops a more sophisticated budget that can challenge prior periods performance and prevents complacency from creeping into the budget.

 

Assumptions in Budgeting

When preparing a budget, it’s important to understand the assumptions being made. Borrowing some of Donald Rumsfeld’s expressions, these assumptions will generally fall into three categories:

1. Known knowns – these are things we can easily predict or have a high degree of confidence in determining. Examples include last financial year’s tax payable in a cash budget or recurring subscription fees in an expense budget.
2. Known unknowns – these are things we can’t easily predict or have a low degree of confidence in determining. They are contingencies we should plan for. Examples include assumed market values of assets or possible damages awarded in a court case.
3. Unknown unkowns – these are things that have a negligible chance of happening or are of little relevance at the time of setting the budget. They are contingencies we wouldn’t necessarily plan for other than as a sensitivity exercise. For example, budgets prior to the COVID-19 pandemic probably didn’t consider the impact of a pandemic on their income streams. Those preparing budgets may have conducted high level sensitivity analysis to determine how far income could fluctuate before there were cash flow issues.

 

These assumptions are then applied to your budget items. For example, in an income and expense budget you might directly reference your profit and loss for the items such as Sales, Purchases, Interest Income, Wages and Salaries. You might even dig deeper into each and identify underlying drives such as number of products sold, work hours for wages etc.

 

Steps to prepare a Budget

Putting this all into context for preparing a budget you may follow these steps:

• Determine the budget’s purpose and choose an appropriate budget format. For example, using an income and expense budget to benchmark and report on business performance.

• Clearly identify the future period the budget is going to cover and the frequency. Determine whether a weekly, monthly, or annual budget is more appropriate.

• Determine who will prepare the budget for your business—whether it’s you, your senior managers, your line managers, or your trusted advisor.

• Determine the budgeting process, considering factors such as time constraints and the expertise of the person preparing the budget.

• Choose the tool you will use to prepare the budget, such as a simple excel sheet, Xero’s built in budget tool, a specialised budgeting tool (such as Syft, Spotlight or Futrli) or a bespoke excel model prepared by Regency Partners.

• Make assumptions and document them for your budget items. Apply these assumptions to your budget tool to produce your budget.

• Finally, review your performance against it periodically. Analyse what the budget is telling you and use it as a platform to start conversations with your team, accountants, and trusted advisors.

 

By following this procedure, you will be able to understand and set a budget that serves as an effective tool in managing your business and achieving your goals.

 

Conclusion

If you need expert assistance in creating and implementing budgets tailored to your business’s specific needs, contact Regency Partners today. Our team of professionals are ready to guide you towards financial success.