The importance of budgeting in your small business cannot be underestimated. Not only does budgeting provide a benchmark against your peers, it also allows for variance analysis and performance assessment, leading to improved sales. Are you actively budgeting in your small business? Read on to learn more on budgeting processes that can help your small business.
Examples of budgeting processes
There are several budgetary processes that can be considered when looking at budgeting and control in your small business.
Incremental budgeting is one, which is based on previous year’s budget or in practice actual results with additions or subtractions of an incremental amount to cover inflation etc the following year’s budget.
This budgetary process tends to be used by the public sector and is particularly suitable for stable organisations. It is a time saving and easy process to implement. However, it does have some disadvantages; as it is based on previous year’s budget prior year inefficiencies could be carried forward and there are no incentives to improve on prior year’s numbers and look for operational savings in your business. Other issues include assuming working methods will continue unchanged and the budget can become outdated.
Another form of budgeting is ‘zero based’ budgeting, a budgeting method which requires each cost in a business to be justified as though the activities to which the budget relates to are being undertaken for the first time. Another way to implement zero based budgeting is to start with a zero balance for each business activity you are monitoring costs for.
Some advantages of implementing a zero budgeting process in your small business include being able to identify and eliminate waste from the start and understanding the costs better for each business activity. Another great advantage is an increase staff motivation; however, there is also the need for increased staff training and the process may demotivate employees due to continuous justification every year when starting back to a zero budget balance. The process will also be more time consuming compared to incremental budgeting and potentially more expensive and there could be a neglect on long term goals.
Incremental budgeting is in fact the opposite to zero based budgeting. In reality, businesses can use incremental budgeting on an ongoing basis and zero based budgeting may be applied when required, for example in a period of change or to particular business activities.
Activity Based Budgeting is another budgetary process to consider which allows you to understand the nature of costs or “cost drivers” and with a focus on reducing them. The advantages include it is activity driven, requiring the need to control activities that drive costs and highlights non-value adding activities and so a major advantage is that your attention is focused on reducing costs. However, it is a complex budgetary system and you may experience staff resistance and staff training will be required. The process may be hindered from the start as it may be difficult to identify cost drivers in the first place. Although a potentially hugely positive outcome in the long-term, there are limited short term benefits of this budgetary process.
Businesses traditionally use budgets as a way of communicating goals and expectations, and form the basis of targets that can be used to assess whether a product, service or employee has performed well or badly. There are drawbacks of a traditional budgetary system and the most prominent ones are:
- Business Environmental unpredictability: Environments are generally unpredictable. Budgets are usually set at the start of the period. For them to be a useful target, the person who sets the budget has to have a reasonable appreciation what the coming period is going to be like. However, in a modern environment where the scope of the competition is often global, customers are global and technology moves on at an ever-increasing pace, in many cases the environment for the next 12 months is not stable or predictable enough to derive targets that are likely to be challenging but achievable. In fact, the targets are likely to end up being set too high or too low. Either is de-motivational if a budget is too tough, people give up or if the budget is too easy people relax. Thus, the very act of setting a target is likely to actually demotivate people in a changing business environment.
- Time and cost: Budgets are time-consuming and costly to prepare. In a competitive world, careful consideration needs to be given to whether the benefits of setting budgets actually justify this cost. It also potentially focuses business owners on a narrow activity rather than allowing them the freedom to manage the business more generally.
- Cost control vs. cost reduction: Budgets promote cost control rather than cost reduction. Provided budgeted costs are met, this is viewed as a good performance irrespective of whether actual costs could’ve been lower.
- Threatening quality: Budgets may threaten quality as budgets are usually expressed in financial terms. The incentive is, therefore, to reduce costs to beat the budget. However, this may threaten quality if cheaper alternatives are used that are not considered to be as good by customers or clients.
- Stifle innovation: New ideas and opportunities may present themselves during a performance period. If these are not part of the budget, then they may well be ignored by management even though they might be good for the overall performance of the business.
- Dysfunctional behaviour: Budgets can lead to dysfunctional behaviour. Business owners, in their desperate efforts to hit budget targets, may make all kinds of decisions that are not actually in the best interests of the creation of long-term shareholder wealth. For example they may focus excessively on the short-term (myopia). They may cut back on training and research and development to reduce costs this year and hit profit target. This is clearly not good for the long-term development of the business. They may try to manipulate results to make them look better than they actually are and this may make business owners unaware of problems. They may make decisions to ensure their performance metrics look good. For example; they may lease an asset rather than buying it to reduce the amount of investment on the balance sheet. This may or may not have been the best decision to financially.
Southside Accounting can help
If you are a small business owner looking for support to grow and stabilise your costs and increase cash flow, Southside Accounting can help.
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Written by Shaima Todd.