There are only 4 outputs every company needs
Budgets are a tool to help you spend money better. But they are often short sighted because they focus on inputs not outputs.
What is a budget?
Let’s start there. A budget is a way of moving decisions down the company hierarchy or forward in time. Here’s what I mean. Say, I’m the marketing person and you’re my boss. In our annual budget, you approve $90,000 in ad spend for the year. You’ve just moved that spending decision to me. Now every time I want to buy an ad, I don’t have to keep asking you for an OK as long as it’s “in the budget.” That’s moving the decision down the hierarchy.
If we budget by month, then I don’t have to report my numbers week to week. I only need to make sure the end of the month actuals meet the budget. That gives me about 4 weeks of flexibility. If we budget by quarter I have 13 weeks. If we budget for the year, I have 52 weeks of flexibility. That’s moving the decision forward in time.
Here are the Benefits
Usually, you want to have decisions made at the lowest point in a company hierarchy. That puts them closest to the action, where (presumably) people have better information.
It takes a lot of work away from the people who approve the budgets. They can make a big decision once, rather than lots of little ones.
It limits cost overruns. If a person doesn’t do a great job of spending money, the budget limits the damage they can do.
Here are the Downsides
Budgets are based on inputs (what you spend) rather than outputs (what you get). This is usually because inputs are easier to measure. But that’s like being on a road trip and measuring your miles per gallon while ignoring whether you’re on the right road.
Money in a budget tends to get spent regardless of results. This is because people are rewarded for staying within their budget rather than spending less. Spending less is easy – but can be devastating if the outputs are not stated. Back to the ad spend. What if the money you budgeted doesn’t bring in the sales you want. Do you keep spending it? Often this assumption is not tested as frequently as it should be.
Budgets can limit the upside as well as the down side. Take that ad spend example. That’s the input. But what’s the expected output? Customers or sales. Suppose you knew that for every dollar you spent on an ad you’d get two dollars in revenue and 25 cents in net profit within a month. Why limit your ad spend to what’s in the budget? 25% return in a month is pretty good. Spend as much as you can till you hit some other constraint.
Budgets can become a crutch preventing good analysis. I realize it’s much harder to figure out what the return on your ad spend is than to track the spend itself. And you may not be 100% accurate. But do the work and get as close as you can. For every dollar you spend, figure out what output you want. Then adjust spending to get that in the most cost effective way.
Budgets are time based. But sometimes the output is not. Some initiatives take more than a year to pay off. So the output in the year you make the budget may look like zero. Again, do the hard work and quantify what partial progress should look like. That way you can see if you’re getting what you need for the money you spend.
Budgets are based on assumptions that can change. Often the assumptions a budget is built on are unstated. Assumptions like:
More advertising brings in more sales.
Hiring another person will increase capacity.
Our customers will pay more for certain features so we need to build them.
Can you see that the expected outputs are implied in those spending decisions but not stated explicitly? State them explicitly so you can tell if things change. We’ve already discussed the first one about advertising. What about the second? Is hiring a person the best way to increase capacity? Maybe, maybe not. What happens if, after you hire one person, you realize you should actually hire two more but it’s not in the budget.
Being explicit in the assumptions that connect your input (investment) to your expected output (return) will not eliminate the need for a budget, but it might make the budget more flexible and give you a framework for better discussions as the year pans out.
The Simplest Changes to Make
Don’t base budgets on what was spent last year. Start from zero and justify every cent you spend.
State the outputs you want to get from the money you spend. Reward people for hitting their output numbers, not just their spend numbers.
The Four Outputs in Every Company
Everything you spend should result in one of the following:
Production – making something customers want to pay for
Selling – getting more customers or more sales
Supporting – all the back office, overhead type stuff that keeps the first two going
Growing – increasing capacity to make or sell.