Four Ways to Build Better Budgets

It's that time of year again: Budgeting and planning for next year are in full swing. Everyone has been through this process. At one end of the spectrum is the struggling business unit that unveils the miraculous "hockey stick" trajectory their sales and profits are just about to take...again. (Don't bet on it.) At the other end are high-performing business units that are starved of the resources they need in order to fund growth because they are subsidizing another business unit's hockey stick.

Through hundreds of sessions like these across dozens of industries, we've identified four best practices to make your budgeting and planning process much more effective and less dependent on illusory projections.
First, set expectations in advance. These sessions should focus on answering some very specific questions in order to allocate resources appropriately. Using a common template will focus each discussion and should simplify apples-to-apples comparisons of both the resources required and the expected results across multiple business units. Make it clear that projections of all types, including the famous hockey stick, need to be supported by facts, and that any key assumptions behind the projections must be detailed. While most of the actual session should focus on the structured discussion, leave adequate time for dialogue and a question and answer period that could take the discussion in any direction.

A second best practice is to build the case for each business unit starting from market demand and working back to internal cost, capacity and capability measures. As simple as this may sound, many of these processes start from internal considerations and only briefly touch on external demand at the end. A really useful fact base about demand goes beyond the "whats" and provides insights into the "whys." Why is demand projected to increase or decrease? Why will we get more than our fair share of the available demand? Why are customers buying in the first place? Given customers' demands, why will our offers win with them instead of our competitors' offers?

This demand context is the starting point needed to ensure that each business unit has realistic projections for ongoing growth and profitability. These analyses should be completed prior to the actual budgeting and planning discussions and should be provided as pre-work in advance of the actual sessions. Once market demand and its key drivers have been established in detail, the discussion can pivot to your supply and its critical internal enablers such as cost position and capabilities. Bringing both the demand and supply elements of the equation together provides the input for more informed decisions while avoiding the pitfall of assuming demand is a "given" that requires little or no discussion.

Next, define the strategic role each business unit plays in the overall portfolio. One way to do this is to use a simple 2 X 3 "Portfolio Matrix" for which the horizontal axis is "Growth Potential" and the vertical axis is "Economics". On the growth potential axis we typically have the leadership team define one boundary between high and low growth potential. For example, the boundary might be above or below average industry or category growth. Or it might be the difference between growing above or below population growth, GDP or the inflation rate. For the economics axis, we usually have the leadership team define high, medium and low levels of performance. The economic assessment reflects the profitability of the business or brand both in terms of margin percentage and absolute dollars generated in order to factor in the scale of the business relative to other business units.

Ideally, each business unit would have the data it needs to plot itself within the six possible roles in the portfolio matrix prior to the budgeting and planning discussions. These roles range from "Growth Engine" to "Manage for Cash" to "Divest," among others. From this initial role assignment, the actual discussions of each business unit may result in reassigning some, all, or none of the business units to different roles within the portfolio matrix.

Regardless of how you decide to define the roles for each business unit, each should have a clear role, and these roles should be transparent to everyone in the budgeting and planning process. Importantly, everyone participating in the process should understand the role for each business unit, how that role was determined and how roles could be changed based on the inputs to and discussions during the budgeting and planning process.

Finally, the actual resource allocation decision should be done vertically rather than horizontally. Too many businesses take a horizontal approach in which resources are spread almost evenly across all of their business units like peanut butter. Before the budgeting and planning process begins, everyone involved should know that a vertical resource allocation approach will be used. That is, resources will NOT be spread evenly and will NOT simply reflect last year's budget plus inflation. Instead, a vertical approach means that those business units that are the top drivers of profits and growth as determined in the 2 x 3 matrix will be fully funded before moving down the list. Business units at the bottom of the list will receive what remains in the budget, if anything.

After the process is completed, all of the participants should know what resources were allocated to each business unit and why. The purpose is to drive understanding and alignment as to why resources were allocated as they were, what performance expectations are going forward, and how changes in performance can change resource allocations in the future.

Jason Green is a Principal with The Cambridge Group.

The 7 Sins of Ineffective Finance and Accounting Teams

The 7 Sins of Ineffective Finance and Accounting Teams:

May, 2012

» Accounting and Finance Teams, Nonprofit Operations & More

The AMS Rapid Diagnostic™ is a comprehensive tool used to assess the financial health of companies and nonprofit organization. While every organization has its own particular financial policies, processes and procedures, smaller organizations can be particularly challenged keeping up with industry best practices since they lack the resources of larger organizations.
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Mental Accounting

Mental Accounting:

Economics is known as the dismal science

This joke might explain why. Three economists went out hunting, and came across a large deer. The first economist fired, but missed, by a metre to the left. The second economist fired, but also missed, by a metre to the right. The third economist didn’t fire, but shouted in triumph, “We got it. We got it”.
While the impression of economists success rate in determining the future direction of economic activity might seem hit and miss at best that is not where the term dismal came from. It appears that it was first used by Thomas Carlyle in a December 1849 article. His comments had much more to do with his disagreement with certain economic principles of the time than being disparaging of economists generally.
It is easy however to be disparaging of economists. For instance, in their supposed role of making weather forecasters look accurate. But if you consider the world we live in – every day millions of people interacting to create literally billions of economic transactions – it’s not an easy task they undertake.

They play a valid role in other areas however. They help us to understand how those human interactions and activity work.

Interesting mental accounting

Consider this story: A husband and wife spend a night in Las Vegas and the man tries his luck at the casino. He vows not to wager more than $5. So he puts his $5 down – on his lucky number, 17 – and wins. He keeps betting on number 17 and he keeps winning, so much so that towards the end of the night he is up more than $10 million. He decides to wager it all one last time on number 17. But this time he loses, and his $10 million gain is gone in an instant. When he returns to his hotel room, his wife asks him, “How did you do?” “Not bad,” he replies. “I only lost $5.”
That’s interesting mental accounting. As far as the gambler was concerned, the only money that was really ‘his’ was the initial $5. Yet he still lost $10 million. The same kind of thing happens in our day to day financial lives. Researchers conducted an experiment in which two groups of people were asked to bid on tickets to a basketball game. One group had to pay cash, while the other could pay by credit card. The average credit card bid was twice as high as the average cash bid. Why? Credit card bidders felt richer because they didn’t have to fork over any actual cash. It has certainly been known in our household that getting an item on sale somehow created a saving that could be proactively spent as a treat – invariably the same afternoon.  Say what!

It is important to look at the big picture

People tend to mentally compartmentalise their wealth. If they have $1,000 held back as emergency funds and $1,000 in credit card debt, at 18% interest, many wouldn’t  touch the $1,000 in savings because it’s for ‘emergencies.’ But if it was used to pay off credit card debt, they could save the 18% in interest charges, which amounts to $180 per annum. They could then use that $180 to start rebuilding the emergency fund and still have the credit card for backup.
Keeping untouchable money in mental accounts like ‘home down payment’ or ‘emergency fund’ can be a good thing of course. The trick is to ensure that our individual mental accounting tricks are working in our favour.

Overlooked Financing Option for Your Business

Overlooked Financing Option for Your Business:
If you need to cash to build your company but aren't keen on draining your personal savings or giving up equity to venture capitalists, there may be another possibility.
Looking to expand? There are the traditional sources: Digging into your own personal savings, loaning from a traditional bank, or finding an angel or VC investor who will fork over the cash for a share of equity.
But there are situations in which none of these is a good option--especially in tough financial times like these. Your personal savings may be skimpy or needed for, well, personal responsibilities. In the current environment banks aren't exactly rushing to help small businesses out and your company may not have the scale or size to attract a VC (or you may simply want to hold on to ownership). So are you out of luck?
No, says Lighter Capital, a Seattle-based company that offers a unique financing option to entrepreneurs: revenue-based financing. Founder and veteran entrepreneur Andy Sack explained how it works on the blog of New York VC Fred Wilson:

A revenue-based finance investment provides capital to a business by "selling" an ongoing percentage of a company's future revenues to the investor. For simplicity, you can think of it as a revenue share type of arrangement. Investor gives capital to company in exchange for a small percentage of gross revenues. RBF lives as a hybrid of bank debt and venture capital. This kind of financing has been around for a while in non-tech industries such as mining, film production and drug development, but it’s recently been gaining traction in the world of growth finance and early-stage technology funding….
Instead of a typical bank loan which requires a business to pay a fixed interest payment, a revenue-based loan receives a percentage of revenues over a specified amount of time, allowing "interest" payments to fluctuate when a growing company has inconsistent cash-flows or lumpy or seasonal revenues…. Another way of saying this is RBF turns loan repayment from a fixed expense to a variable expense.

Loans average $100,00-$250,000 and most are paid back within three years at a rate of 15% to 30% annual interest. Lighter Capital has lent around $2.5 million since opening its doors in November 2010, and stresses its model is particularly valuable to businesses with "lumpy" revenue, such as seasonal enterprises.
So what sort of business is a good fit for RBF, and what's the experience of financing your business this way really like? Inc.com called up an entrepreneur who has used the model to find out. Eric Estoos is the CEO of HarborCloud, a Bellevue, Washington, company that hosts small business applications in the cloud. He looked to Lighter Capital for funding when he wanted to grow his business but didn't want to give up any equity.
"This type of model is appropriate for a business that's getting some traction and is seeing some return on the resources that they've got and want to take the next step up before going to more traditional VC or angel funding," he says, adding that "for a business that has revenue, has their bases covered as far as their monthly net and is just looking to grow the business and needs some capital to do that, it'll make a lot of sense."
He has used the financing from Lighter Capital to hire for his growing company and pronounces himself satisfied, though as with every move in business, there are trade-offs.
"The money is a little more expensive than, say, traditional bank financing. However, for a business that's only been around two, three, or four years banks really just aren't lending, so it's really tough to try and get any leverage from a bank," he says.
And Fox News Small Business has reported another major downside to carefully consider: "if the borrower becomes delinquent on the loan after a set time period they stand to lose everything--their business, patents, domain names and trademarks-- to Lighter Capital."
Estoos, however, feels that getting funding from the team at Lighter Capital, all of whom are experienced entrepreneurs themselves, has other subtler advantages that counter-balance the risks for him.
"The payback is tied to my success, so I feel like they have more of a reason to stand behind me and help promote my business, as well as provide a vehicle for a second round, which we have done. They've also provided a lot of other resources from the standpoint of just [being a] great group of guys to bounce ideas off and help steer the ship. And I felt comfortable that I'm getting solid advice from them because they have everything to gain from giving me good advice."

The Only Three Reasons Entrepreneurs Need Accounting and Finance

The Only Three Reasons Entrepreneurs Need Accounting and Finance: Observing finance and accounting professionals? or the way academics at most business schools train them ? might lead you to believe that finance and accounting is a complex and arcane language understood only by an initiated few.  For an entrepreneur, the truth is that accounting and finance are only tools to accomplish three key tasks:

5 Tips for Forecasting & Maintaining Cash Flow

by Sara Hottman 

“It’s not necessarily the big hole that’ll sink a ship; that one you can plug. It’s the hundred little pin holes that are hard to find,” says Al Titone, the district director of the New Jersey Small Business Administration.
With the economy still in unstable territory, experts say you need to be extra vigilant about cash flow, carefully monitoring fixed and incidental expenses in order to reserve enough cash to survive uncertain times. Titone says you should question the necessity of all expenses — whether it’s a car or a brand-name printer cartridge.

The Small Business Administration recommends keeping the equivalent of six months to a year of operating costs in reserves. The key is relatively simple: Analyze your expenses as regularly as possible. Here, experts reveal a few basic tips to forecasting and maintaining cash flow in an uncertain economy.

1. Calculate your break-even analysis. Business owners should start the budget process with a break-even analysis, the equation that shows a business’ base cost to provide its product or service, says John Welch, a San Francisco-based CPA and attorney who specializes in small businesses. In his experience, most business owners, preoccupied with covering daily expenses and making payroll, don’t perform the analysis annually.
Dig Deeper: How Risky Are Cash Advances?

“In an uncertain revenue world, the idea is to keep fixed cost to the minimum to run the business, and then really manage variable costs,” Welch says. “As a business owner, it becomes an administrative burden to do it. … But in an uncertain world you have to be more proactive about managing expenditures and matching the revenue levels you’re anticipating.”

2. Re-evaluate fixed expenses. Many business owners don’t second-guess fixed expenses like rent or insurance when setting their annual budget, even though those base expenses represent the largest bite out of cash flow, Welch says.
Switching carriers for employee health insurance or moving offices if location isn’t critical to a business could represent substantial savings. Or, Titone suggests, try to renegotiate rent; business owners have some leverage in a bad market.
Dig Deeper: New Rules of Getting a Small Business Loan
“Make sure fixed costs commiserate with revenue level,” Welch says. “Then variable costs, really beat them to death.”

From the owner’s perspective, he says, money left over from base costs either goes to variable costs or back to the business as profit; the more tightly it’s monitored, the more could potentially become profit.

4. Schedule a monthly check-up for tax purposes. Welch also suggests business owners perform a monthly analysis of income and expenses so they know through the year what their tax bill will look like.
Tax analysis requires keeping books on a cash basis as well as an accrual basis, he says. Most business owners keep books on an accrual basis — recognizing receivables and payables — and then for taxes adjust books to a cash basis — the difference between taxable income collected and cash expenditures made, which is taxable income.
Dig Deeper: Is a Microloan Right for You?
“That’s part of this whole cash flow planning process,” he says. “That way they’re not surprised by a big tax bill.”

5. Evaluate variable costs every six months. Businesses should regularly — on an annual or, preferably, semiannual basis — audit variable expenses such as office supplies for necessity, which most business owners neglect to do, experts say.
“You should always be second-guessing expenses, even in a good economy,” Titone says. “If you’re doing OK right now, it’s a good time to lock in cash flow.”

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