This budgeting guide explains which five sub-budgets a company needs to build to create a comprehensive, clear, and easily adjustable cash forecast. The purpose of this guide is also to clarify what a budget consists of, how it is built, and how it should be managed.
Two ice hockey teams are aiming for the Olympics in three years. One team decides not to prepare and calls players directly to the games. The other team decides to start preparing immediately by calling key players to the team right away. Additionally, this team decides to rotate players in quarterly training camps to get the best feel for a well-coordinated team, measure player development, and commit players together.
Which team do you think finds it easier to adjust their training when they notice something is not working as expected? Which team finds it easier to learn from mistakes? Which team's players do you think will be more motivated during the three-year training period? Which team could teach us more about profitable business?
Sub-Budgets
The team's training program and the target results at the end of the training program for different areas are comparable to a company's sub-budgets. Comparing results to regularly made sub-budgets helps understand what is achievable and what the realities are.
The most common way to create sub-budgets is to divide them into sales, variable costs, marketing expenses, fixed costs, and investments. From the entirety of sub-budgets, a cash forecast can be compiled, through which the company and its stakeholders can view the development of the company's cash position.
Let's start with sub-budgets.
1. Sales budget
There is no single right way to make a sales budget, as factors affecting the sales budget are industry and company specific.
For example, a machine shop manufacturing hydraulic cylinders can base its sales forecast primarily on purchase estimates from customers, previous fiscal year actuals, and projected growth. A software company, on the other hand, can form its sales budget based on historical sales figures and proven growth.
Despite there being no single right way to make a sales budget, creating a realistic sales budget is one of the most important steps in budgeting. The reason for this is that other sub-budgets are often closely connected to the sales budget, and without a realistic sales budget, a company can easily drift into a cash crisis when expenses grow larger than income.
Additionally, a realistically made sales budget can be utilized as part of goal setting and rewarding, which helps get the company's personnel rowing in the same direction.
2. Variable costs budget
Variable costs in budgeting primarily refer to costs related to the service or product being sold, as well as variable salary costs. Most often, the variable costs budget is prepared based on the sales budget.
Tuotanto- ja valmistusyritykset: In production and manufacturing companies, variable costs include, for example, materials, supplies, and energy needed for product manufacturing, the consumption of which is often directly proportional to the consumption of sold products.
Kaupan alan yritykset: In retail companies, variable costs often include the purchase costs of sold products including delivery costs.
Palveluyritykset: For service companies, the share of variable costs from sales is naturally often smaller than in production or retail companies. For example, for transportation companies, variable costs include tire and maintenance costs as well as fuel costs.
3. Marketing budget
Marketing costs refer to all costs planned for marketing. Marketing costs are smart to divide on a monthly level due to seasonal variations and cash forecasting, as marketing investments also usually vary seasonally.
4. Fixed costs budget
Fixed costs refer to costs that do not depend on the products or services sold by the company. These include rent as well as fixed salaries and related social security costs and accruals.
When budgeting salaries, it is good to also pay attention to social security costs as well as holiday pay liabilities and holiday bonus accruals, so they do not come as a surprise.
Example: A company pays salespeople 3,000 euros per month. Social security costs amount to about 20% (€600/month). Holiday accrues at 2.5 days per month. Holiday pay liability is about €360/month and holiday bonus €150/month. Total to budget is €4,100/month/person.
5. Investment budget
Investments refer to acquisitions of intangible or tangible assets that are expected to generate income for the company usually for more than 12 months.
For example, Machine Shop Ltd might calculate investing 250,000€ in a new overhead crane, of which it plans to finance 150,000€ with a bank loan and the remaining 100,000€ from its own cash.
Before implementing an investment, it makes sense to verify that the company's cash will withstand the self-financing share and possible loan repayment. This is possible when the company has prepared a realistic budget.
Budget scenarios
If something unexpectedly negative happens, the company may drift into a cash crisis. Therefore, we recommend building alternative plans in advance.
For the main budget compiled from sub-budgets, it makes sense to create best case and worst case scenarios in addition to a neutral scenario. They help prepare for unexpected situations.
Forecasts
To succeed, a company must learn from its mistakes and optimize its operations. Thanks to forecasts, the remaining period can be updated to reflect the current situation and necessary actions can be planned well in advance.
By creating shorter-term forecasts alongside the annual budget, the company can monitor the development of its financial situation more closely and react faster.
Top-Down and bottom-up budgeting
Budgeting in companies is usually driven either top-down or bottom-up. In the former, company management sets financial targets that are delivered to the executing party.
In a more participatory model, the direction is reversed. If each salesperson could budget their own sales for the upcoming period, the budget would be bottom-up driven.
Monitoring actuals
Comparing income statement and balance sheet actuals to manually made budgets quickly becomes laborious. A popular alternative is financial management software where actuals are updated automatically.
Monitoring actuals has been made so effortless that anyone can do it. The budget and its variances can be quickly read from concise visual graphs and charts.
