In part two of our Ask An Accountant – How To Budget For Your Business Series, we looked at what you should do if you exceed your business budget.
Today, we take a look at contingency budgeting, how you can incorporate scenarios into your budget and much more.
How should I think about contingency budgeting?
A contingency budget is an amount of money that is included to cover potential events that are not specifically accounted for in a cost estimate. The purpose is to compensate for the uncertainty inherent in cost and time estimates, as well as unpredictable risk exposure.
A contingency is something that may or may not occur, but that must be dealt with if it does.
The word contingency implies that the potential of an event is foreseeable. In business, contingency plans are drawn up to specify foreseeable potential events, the actions to be taken to address them and the resources that will be required to do that, including money.
How should I incorporate scenarios into my budget?
Budgeting involves applying estimates based on past performance to future goals. However, a company’s past performance may provide little value in perceiving how it will perform when faced with new challenges.
This is where scenario planning becomes a useful tool that helps remove some of the uncertainty inherent in your budget.
Scenario planning assists companies in adhering to their budgets and achieving their financial and operational goals. It analyzes possible situations and shows how these can impact the budget and the ability of the company to achieve those goals.
It can also show you how resilient your business will be to market or other changes outside of your control. This can provide vital input when making strategic decisions.
Scenario planning can be a complex process. McKinsey & company’s “Overcoming Obstacles to Effective Scenario Planning” provides some useful guidance:
Should I consider KPIs when preparing my budget?
A key performance indicator, or KPI, for budgeting can be an effective tool to keep track of a company’s financial health.
KPIs are measures that a company can use to monitor its progress throughout a specified period.
By closely managing budgets to achieve a KPI target, a company can reduce unnecessary spending and improve its bottom line. KPIs also help a company plan future spending. These can also be used as part of the staff incentive plans, which can motivate positive staff behaviour and increase productivity.
What is your advice to someone creating a startup budget?
As it is difficult to predict the costs and revenue for a startup, you need to ensure that you perform research about other businesses that are similar to yours to see what the general startup costs are for that specific industry.
It may also be useful to involve outside business consultants and accountants who have the necessary expertise to guide you through the process.
Due to the tough economic conditions that businesses are currently operating in, it would also be wise to be conservative in estimates.
This will ensure the viability of your business, particularly in avoiding unwarranted spending that can prove to be extremely costly and threaten its long-term prospects.
Other budgeting tips and tricks:
When reviewing performances against budgets, it is always important to adapt or “flex” them for the level of activity that is most relevant to you.
An example of this would be a manufacturing company that has recently started its operations for a new product that it is going to make and sell.
Its budget would have been prepared based on initial sales targets and production volumes. A few months in, demand for the product might far exceed expectations, resulting in the factory needing to produce a lot more than initially expected.
It would therefore have to incur a higher level of costs but would also sell more.
You would therefore have to adjust your budgets to reflect this to get an accurate and fair review of the performance against the budget.