Budgeting in the “New Normal” Economy
Smart companies typically spend the end of each year planning for the next. But this year (thanks to our ever-changing economy), even the smartest business owners have questions that make even simple annual planning anything but typical.
This year, business owners are asking:
When will the economy return to its pre-2007 status?
How will its return affect my business?
How on earth can I predict what will happen next year when I could not have predicted this year?
Is planning for 2010 just an exercise in futility?
The truth is that end-of-the-year business planning is no picnic. It’s difficult even under the best circumstances. That said, we always recommend having a plan – one that includes at least a budget and cash flow projections for the upcoming year. But in a time when unpredictable is the only thing that is predictable, the question is: Where to start?
One of, if not the most, challenging part of planning (especially, in the “New Normal” economy) is predicting revenue. While we certainly don’t have crystal ball to tell you how next year will play out, we can offer advice on how to approach revenue prediction. Be aware that this is more of an art than a science.
Let’s get started by looking at your 2010 revenue:
Begin with your signed contracts and predict monthly revenue from those. We suggest starting here because we prefer to watch your big picture emerge from the details of individual accounts. Companies with long-term contracts and predictable business models may find this a relatively easy exercise. But most companies are not in a steady-state, predictable situation. For those companies, it can easier to make predictions after examining each contract alone.
We also suggest adding two additional components to your revenue forecast (particularly if you own a service company). These are:
1. Predicted revenue from current prospects, adjusted by the probability (your confidence) that the prospect will become a sale.
2. An estimate of accounts/contracts that need “to be found.” These prospects are not on your prospect list – yet – but they are what your sales department will need to land over and above the contracts you’re currently working on. “To be found” contracts may also correspond to sales targets for the sales people in your company. Note of caution: Since revenue targets set the stage for the rest of your budgeting and needed cash flow, we caution you to be conservative in your estimates here.
Next, take a look at Cost of Goods/Services:
Predicting cost of goods/services is likely less difficult than predicting revenue. Typically, cost of goods is a percentage of revenue based on historical costs and adjusted for price changes, efficiencies and other current conditions. For some companies, cost of goods/services also includes salaries and benefits associated with certain positions.
Administrative Expenses are next. Often, these are evaluated account by account and there is typically more predictability. If your company is established, historical trends can be relied upon. But if your company is younger, a bottom-up approach might make more sense.
At this point in the planning process, the components of your budget are complete and it’s time to take a look at the big picture.
If your expenses are higher than your projected revenue, you need to ask: How can I generate more revenue where can I cut or defer expenses?
We also suggest you include a cash flow projection in your year-end planning. It’s important to predict if your company is going to experience any periods of negative cash flow. Factors that affect cash flow include the timing of customer payments, arrangements with your vendors, inventory expenses and expenditures for capital and software development.
The complexity of your budget process will depend on several macro and micro factors. Macro factors include overall economic conditions, the status of your industry and where you are in the life cycle of your business. Micro factors are those issues that currently exist in your company. It’s generally prudent to base expenses on a conservative revenue model.
Ultimately, we advocate having two budgets: one that’s conservative and one that’s a bit more aggressive. That way, you’ll be better prepared no matter which way the economy goes.
Of course, a budget is academic unless it is shared with the appropriate level of management and used to measure against actual results. Additionally, budgets need to be dynamic. Many of the assumptions you will use to create your budget (and next year’s plan) will be stale the minute the New Year starts. This is why having a solid process to re-evaluate and re-project is so critical.
And the absolute best time to being that process is now.