In part 2 of this CPD mini-series, Ray looks much more closely at how to model your business budget in the real world – not ‘fairyland’ as he calls it.

OK so it’s the start of a new financial year and you’re thinking about the year ahead for your business. With so much uncertainty on many fronts for all forms of business, you probably had your heart in your mouth when you developed your forecast budget for the 2013 financial year (you did prepare a budget, didn’t you?). After all, once you commit a budget to ‘paper’ it’s just a set of numbers the realisation of which you have limited control over.  So how can you begin to take a set of numbers and make them really count in your business over the next twelve months?

The starting point has to be an honest, realistic, approach to the numbers you load into your budget spreadsheet.  The truth is that you can get a spreadsheet to give you any answer you want it to – it’s just a matter of the assumptions you use in your forward estimates.  But impressive numbers count for not a lot if they’re just nice to look at with little prospect of being achieved in the real world.

One thing is for certain: the vast majority of business failures have one common ingredient: unrealistic assumptions.

Start with what you know

Budgets are almost ‘living and breathing’ in that the Actuals can have swings and variances that at times won’t bear much similarity to the ‘Forecast/Budget’. So, the place to start with budgeting is where you will have the least likelihood of variances and that’s almost always in the Expense component of the budget.

In this regard you will know what your Fixed Costs are: salaries and superannuation, office rental and associated costs, utilities, research, software, insurances, cleaning and so on. These you know, within reason, will be relatively stable throughout the year.

Of course Variable Costs like marketing, postage/freight and the like are where you have less certainty but also have more control. For example, you’ll most likely have a hard time convincing your landlord to reduce your office rent whereas you can make a decision to reduce your advertising and other forms of marketing if your cash flow starts to look threatened during the year.

Once you have completed your expense budget you know how much revenue you need to generate in order to just break even.  This then gives you the information with which to understand if you have priced your services correctly.

Recurring fees

This ‘line item’ can be classified as both a ‘known’ and ‘unknown’ in your budgeting. To a reasonable extent, you can forecast what your recurring fee revenue will be regardless of whether it’s asset based or fixed/hourly rates.

Of course, the greater variance in recurring revenue could arise in asset based fees businesses and for that reason alone, arguably, recurring revenue might also be regarded treated as ‘unknown’. However, for the sake of this discussion we’ll regard it as a ‘known’ but come back to it later to account for the possibility of it being unknown.
What don’t you know?

Over the years I’ve seen enough budgets in various organisations to know that it’s the revenue budget that most often is where budget forecasts come unstuck.  While, as per the above, within reason you can forecast your existing revenue as it recurs over the coming financial year, it’s the growth of new client numbers and related revenue which is most problematic.

It might be intellectually stimulating to forecast impressive numbers of new clients based on average fees per new client and the subsequent average recurring fees from such clients, but the real world is often very different and there is absolutely no sense in budgeting with unrealistic revenue expectations.

Yes – you’re right – that should be budgeting ‘101’ but it happens far too often in all forms of business. Financial advisers are not immune from ‘living in fairyland’ when it comes to revenue expectations.

The indisputable truth is that you really don’t know how many new clients will actually engage you next month let alone in the last month of a financial year so what’s the point in deluding yourself and others with unrealistic forecasts?

It might be tempting to ‘fatten’ the forecast new client revenue to keep a lender happy, for example, but that only makes for difficult discussions down the track. Be realistic and conservative in what you forecast.

By maintaining a realistic approach to budgeting you create a business planning culture that is less stressful when the ‘Actuals’ don’t resemble your forecast budget. By making allowances for the real world to be different to the spreadsheet, you’re giving yourself more control of your business destiny.

What if?

So, if the future is somewhat unknown, save for fixed costs and a reasonable assumption on recurring revenue, what if:

• No new clients engage your firm in the budget year?
• Your assets based recurring revenue declines by 10% or 20% or more?
• You lose clients due to markets; perceptions of service; perceptions of value for money – you name it, what if you lost clients?
• Your variable costs rose above what you anticipated; above inflation, say?
• New legislative imposts simply added to the cost of being in business?
• You don’t have the capacity to increase your fees in response to higher costs (read: existing/new clients won’t accept higher fees)
• You have underpriced your services, but can’t increase your fees to clients?

Sensitivity? Analyse it!

If you are now unnerved by anything on the above list then you need to do some planning around such scenarios and possibly others not listed.  One key problem with budgets is that it’s too easy to get lulled into a false sense of security with numbers that give you the answer you want to see rather than giving you a set of truly meaningful numbers. The success of budgeting is partly dependent on testing the veracity of the numbers in your forecasts; in other words you need to analyse the sensitivity of the forecast outcomes showing up in your ‘bottom line’.

The ‘What if?’ scenarios referred to above need to be tested and that can be done with relative ease through a so-called Sensitivity Analysis – it really is quite straight forward. Simply copy the budget data to either a new spreadsheet or paste alongside the existing numbers. Then, apply equations in cells to reduce income by, for example, 10%, 20%, 25% – it’s entirely your call on what level decline in income you analyse.

The results should just filter through to the literal bottom line – the profit/loss line – in your spreadsheet give you much greater insight into where your business will be at under certain scenarios.  Of course, if you’re ever the ‘glass half-full’ type of person, you can model the upside as well in terms of revenue increases.

In reality

A ‘real world’ approach to budgeting is far more beneficial to you, your employees and your clients than a dreamy set of numbers that look nice but lack substance. By making provision for the real world to be different to the spreadsheet, you’re giving yourself more control of your business destiny by giving you much greater insight into what actions are available to you in order to keep the doors open. It’s all well and good to plan for success, but you need to keep your planning real.

At the end of the day, this is simply one form of business risk management and that’s a component of each and every well-constructed financial plan.

Keep it real, man!

18 July 2012
 

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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