Budgeting as an Effective Control Tool

“Budgeting” in the context of business can be defined as the process of estimating the finances of a particular business for a future period and planning its operations accordingly. Understood? Yes, me neither, for the first four times. It is actually not that hard of a concept to grasp, though. Let me break it down for easy digestion.

If you are saying that you have no idea whatsoever with regards to what budgeting is, you are (inadvertently) lying. This is something that we do each and every day, every month. You might have done some budgeting even before you got here to this article. Tell me this, did you or did you not think, “I am going to read this article for a minute and then go watch some TV drama for an hour”? This is also a form of budgeting. We budget our time, which is a precious “resource”. In this case, we budget it to be spent in a future period of time. Understood the concept now? Good.

Key steps in the budgeting process

Step 1: Assess the market situation

• Check if your business can make the same value of sales as the previous year 
• Check if there is a possibility for the business to increase sales
• Check your target sales figure for the upcoming year

Step 2: Check if your target is feasible in the current market environment

• Check if you have enough resources (this used to be considered as the land, labour and capital as needed, though today’s businesses may not reflect that mix) to achieve that target
• Check if your current resources are in fact capable of achieving that target – can the machinery handle it, are the people sufficiently trained?
• Check if you should be investing in more/ better resources or not 
• Check if the current management resources are capable, and sufficient to manage the said resources

Step 3: Consider the costs

• How much would your wages need to rise – the market may not be standing still, and you may have made commitments to your employees
• How much are raw materials likely to cost
• How much would storage cost
• Check for the additional machinery and machinery maintenance costs 
• Check if the other cost types would remain the same

Step 4: Now, check how your targets can be funded

• Check if the business has enough money to fund the extra resource requirement 
• Check if you should increase the price and if yes, by how much
• Develop methods to reduce costs
• Check for financing options such as bank loans

Alright, when you have gathered all this information you are ready to start making the budget.

Using the Budget as a control tool

Now that you have an idea as to how to prepare a budget, let’s move into the most interesting aspect of this lesson. We both know that it is a tad too hard to balance cash inflows and outflows at an optimum level. It is natural that the business will do really well when there is a rich inflow of cash but not when the inflows are down. However, this should not be the case. When there is a budget, you can manage your cash outflows so that the business remains stable even if there are unforeseen cash outflows. “But how?” you may ask? Well, there are certain types of costs that you can cut down and there are certain types of costs you have to bear, regardless of your sales output. Each type of costs has to be treated differently when it comes to cost control. Let’s find out what they are. 

Variable Costs and Fixed Costs

Variable costs are the types of costs which will change according to a change in the output. If you are to increase your production, the variable costs will inevitably increase in relation to the production increase and vice versa (e.g.: Raw material costs, Packaging costs). Now, how do we minimize this type of cost?

• Try to buy only what is needed for immediate production
• Try to produce only what you are sure to sell
• Keep stocks as low as possible
  • Stocks cost money and carry risks
    • Storage
    • Obsolescence
    • Theft
    • Damage
  • Retail businesses should have a fast-moving supply chain with little excess inventory in storage anywhere along the chain
• Buy on credit wherever possible
• If possible arrange to pay for purchases only after the goods are sold and the cash received

Next up, fixed costs. Fixed costs are the opposite of variable costs. These do not vary with the changes in production levels. However much the production levels increase or decrease, the fixed costs tend to remain the same (e.g.: Rent, Insurance). So, you might be wondering, “if they do not change, then how on earth do I control them?” Well, you will not bring down the fixed costs by reducing expenses related to the sales side . However, you can bring down the level of fixed cost by taking steps in the correct direction. 

• Carefully set an amount to spend each month and stick to it

• Consider hiring staff on part-time contracts and increasing their hours as sales grow, or hiring daily contractors instead
• Make expenditure control a key performance factor for senior employees
• Consider outsourcing some functions
  • Accounting
  • Payroll
  • Transportation (why pay for idling lorries?) / distribution
  • Marketing / Online marketing
  • Quality control
  • Cleaning

Now, let’s wrap it up. I understand that this is a lot to take in. Let me summarise. The budget is an important control tool you can use to manage your future cash inflows and outflows. Carefully plan your expectations and their feasibility and put them on paper. Then, analyse what types of costs you will incur in the time to come. Depending on the cost type, work on reducing the costs. Then you will be left with a top-class budget that will keep your organisation on track and achieving its targets. When it comes to the actual budget-setting, there are certain best practices and different types of budgets you can adopt, depending on your business. Let’s dig deep into these areas in a separate article.