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Sunday, 18 February 2018

Budget Time Coming Round? Try Dynamic Budgeting Instead!

Over the recent past I have been banging on about the value or otherwise of annual appraisals of team members as well as the danger of running the business metaphorically using the annual accounts.

It occurs to me that the value of the annual budgeting exercise also needs to be examined. First of all, what is the purpose of the annual budget other than the fact the auditors demand it so that they can report to HMRC (or the IRS) and the bank also likes (!) to see them?

If asked most business leaders would say that the budget gives them an opportunity to monitor performance against an acceptable and carefully crafted standard.

Oh yes?  The number of ways of devising the annual budget is as the sands of the sea and in many cases, just about as useful.

I have known situations where the budget was written by the finance department without any reference to activity; the numbers alone seemed to be far more important. 

In other cases the sales department has the honour and carefully assesses each major customer in an effort to guess what their turnover is likely to be in the year, and so on.

Having gone through that process with a former employer, part of a large conglomerate, we were told that the projected profit was inadequate and needed to be increased.  The helpful head office accountant suggested that we increase the estimate of turnover and reduce costs like, for example, marketing.

A very bright idea but we did as suggested and, lo and behold, the budget was accepted.  Sadly however performance was in accordance with our original estimates and far away from the amended version for which we were, to say the least, castigated.

“It’s your budget” they said: “Why are you not meeting it?”

My old friend and Vistage speaker, the sadly missed Brian Warnes had other ideas about the value of the annual budget.  Brian had an interesting career leaving university to start life as a physicist. He then was commissioned in the Household Cavalry and did strange things as an intelligence officer.

On leaving the army he then retrained, for heaven’s sake, as an accountant. Perhaps because of his scientific and military training he rebelled against the tyranny of the annual budget which he described as generally being a “limp forecast of mediocre performance” and devised an entirely new concept which he called Dynamic Budgeting which was, to all intents and purposes, break even analysis.

Break even is calculated from the “five line P&L” which is:

Sales (volume and price)
less variable costs (labour and materials)
= gross profit (margin expressed as a percentage of sales)
less fixed costs
= net profit (margin expressed as a percentage of sales). 

To calculate break even sales, fixed costs must equal gross margin.  Therefore divide fixed costs by the gross margin percentage.

The clever trick is to keep the break even sales below 75% of actual sales ad this calculation can be done weekly for example. It gives the leader a view of the trends so that if the break even percentage of sales is increasing, then action needs to be taken to increase the gross margin which is, after all, the true revenue of the business.

If this is on the leader’s IT system plotting both actual and break even sales on a rolling annual basis then it is feasible to keep a regular check on profit performance and make quick changes should they be necessary.

Annual appraisal v. regular one-to- ones?  Conventional budget v. dynamic budget?  I know which I prefer.

Read Brian’s book, The Genghis Khan Guide to Business (http://www.amazon.co.uk/Genghis-Guide-Business-Charles-Warnes/dp/0950943207/ref=sr_1_2?ie=UTF8&qid=1360330400&sr=8-2) and change your life (or your Finance Director)

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