Budgeting Your Bets vs. Betting Your Budget

In mid-August, with the Red Sox languishing 10½ games back of the Yankees, my young friend Noah sent me an email: “I bet you that the Sox finish no worse than 5½ games back.”

“What would you like to bet?” I e-replied.

“Well, I only have $3.15 and Mom says I shouldn’t spend more than $1.00 on this.” So we settled on a dollar.

At the age of ten, Noah is learning about budgeting.His financial advisor (his mom, my oldest daughter)has influenced his spending. Mom knows about this stuff because for several years she tried to wing it without a budget and occasionally discovered that there were more days in the month than there was cash.

Many companies discover that the hard way, too.The accounting staff is so busy meticulously accounting for history that they neglect the future. The CEO on the other hand, is concerned about how many weeks of payroll he/she has in cash and whether or not the cash can be stretched to cover the rent, utilities, and the Amex bill when each is due this month.

Who’s doing the financial planning here? Who’s in charge of making sure that the economic model is still working?

Mom has figured it out. She knows that Grandma used to have a bunch of glass jars in the kitchen cabinet into which she’d apportion each paycheck – so much for the mortgage, so much for groceries, for dry cleaning, for gas, etc. When the car’s transmission gave out, she knew that she had to siphon funds from each of the jars to pay for it, and she knew which jars had discretionary money to make it possible. These days, Mom relies on Quicken, but the basics haven’t changed.

The best companies operate the same way. Their revenue projections are based on their most recent history, not on an illusion of an imminent increase in income to offset increasing expenses. What they spend is determined by a solid understanding of their costs – not only their employees’ salaries, but the related SUTA, FUTA, workers’ comp., and benefits package for each individual. Not only the rent, but the utilities and the real estate tax bill. Not only the trade show registration fee, but the cost of shipping and setting up the booth.

Most of your expense levels for next year have already been established this year. You know what your materials costs per unit are. You know how much the product brochures cost. You know what the auditor’s fee was for the year-end work. Each of those and 20-30-40 other categories is a separate jar. Start out by describing what’s in each jar (account), then determine what it cost you this year (see the general ledger detail), then modify it by what you know is going to happen next year.

Do the same thing for your income. List all of your customers by total annual revenue for the past three years. Consider each in turn – trending up, down, or sideways? Why? Do you want a different overall result next year? How will each of these revenue sources, and others, help you achieve it?

Budgeting isn’t hard, but it takes discipline and persistence. It’s a trial-and-error process that thrives on the feedback loop of monthly variance analysis: why did you have money left in that jar last month, even as you ran out of it in this one? What’s the implication for next month, and for the next twelve months? How do you reposition your bets, based on the latest information?

Noah knew. Three weeks after our first exchange, the Sox were 2½ games back. Another email. “Let’s go double or nothing on beating the Yankees.” He’s only in fourth grade, I thought. He must have gotten a new financial advisor – his older brother.

Andrew, who knows what it is to be a Sox fan, is sucking him in. Budget or not, another Howe generation is destined to learn the hard way about the Red Sox.

Alligator Bites

Five common budgeting mistakes

    1. About revenue:“We’ve increased15% this year. Let’s be conservative and say we’ll be up 10% next year.”You have to analyze revenue components and build the budget from the ground up (see lead article) to know where those additional sales are coming from.
    2. “We’ve been short on sales for the each of the first three months. We’ll just have to make it up during the rest of the year.”A recipe for disaster. Generally, if you’ve come up short for three months, you have to make the tough decisions about cost reduction, and your budgeting notes should point toward the discretionary expenses.
    3. “Unfortunately, we should figure overhead expenses will increase by 10% in 2005.”Well, maybe. But for sure, unless there’s a commitment to analyze each line item with a commitment to find savings and the discipline to control spending.
    4. “Just divide the annual total by 12 to determine the budget for each month.”For expenses like lease payments, most insurance premiums, and rent, that’s reasonable. For everything else, it’s a cop-out.You need to budget for the seasonality of expenses in order to know whether you’re running ahead or behind month- to-month.

And – worst of all:

  1. “Our first pass on the budget shows us losing money.Clearly, we have to increase sales.”If you can’t budget a profit at a given level of sales, you may not have a workable economic model. But most often the problem is a failure to control expenses aggressively.That’s what the second pass on the budget is all about.

Draining the Swamp

“Numbers And Metrics You Can Use Right Now”

What’s your company’s basic economic model?

If you’re a manufacturer, your targeted gross margin is probably 40%, and your budget might look something like this:

Net Sales 100 %
Less: Cost of Goods Sold 60 %
Gross Profit 40 %
Sales & Marketing 15 %
General & Administrative 10 %*
Research & Development 5 %
Net Income before Taxes 10 %
*Includes most of owners’ compensation

On the other hand, if you’re a service business, the breakdown could be closer to this:

Net Sales 100 %
Less: Cost of Services Provided 33 %
Gross Profit 67 %
Sales & Marketing 25 %
General & Administrative 8 %
Net Income before Taxes 34 %*
*Includes most of owners’ compensation

Either way, or with the many variations in between, the key is to understand the basic economic model for your industry. The best source is through the Annual Statement Studies™ of Robert Morris Associates, accessed at most business libraries and at rmahq.org.