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Why budgeting is important for businesses chasing cost control

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Why budgeting is important for businesses chasing cost control

Many successful business owners find themselves worrying about cost blow-outs, how to find new audiences for their products or being undercut by the competition. Much of this stress can be controlled with better planning which is why budgeting is so important for business.  

Some finance managers and business owners continue to rely on simple static budgets using historical data to manage and predict revenue and costs. As a result, business owners face challenges in reviewing and adapting business budgets to align with the expectations of internal business partners, overall strategies and to react to monthly fluctuations.

While this approach may have sufficed in the past, it overlooks the potential benefits of more comprehensive budgeting practices that enables finance teams to budget in more detail and to compare budgets with actuals once the books are balanced each month.

Containing costs can be challenging due to limited visibility caused by incomplete budget data, reliance on static budgets, and a lack of transparency throughout the organization. A static budget, also known as a fixed business budget, remains unchanged throughout the budget term.

Business owners and finance team need to evolve from using simple budgeting methods relying on historical data to comprehensive live budgets that can be linked and checked with actuals as you balance the books each month and be ready to reforecast. This is crucial to achieve effective cost control and contemporary financial management.

By recognizing the value of integrated planning processes that is linked to financial statements, business owners can empower their organizations to make informed business decisions, optimize resource allocation, and drive sustainable growth in today's competitive landscape.  

Costs can be an ever-threatening presence like the giant squid from Jules Vern's classic novel, 20,000 Leagues Under the Sea. In it, Captain Nemo was able to escape the beast by cutting off one of the giant tentacles with his axe that wrapped itself around the Nautilus. While it is not feasible to simply ‘cut off’ any one of the numerous variable costs like Captain Nemo, implementing effective budgeting processes with a consolidated view of all financial and operational data will enable you to plan within the fiscal year, and determine what the drivers of cost are and manage these costs in much detail. Take for example a significant cost such as headcount or remuneration, in a budget platform like Phocas you have with inbuilt tools to manage all the data so you can manage the expense around when people start and leave, the different payments for bonuses and health care per region and allow for payrises to commence at different times during the budget year.

Downsides of using inadequate business budgeting processes

Static budgets have long been a staple for many organizations seeking to control costs including raw materials, cost of goods, fixed costs, and operating expenses. They do not account for fluctuations in cyclical or seasonal demands, which means that they may not accurately reflect the changing business needs. During the year-end budget review, the customary approach often involves employing the incremental budgeting process. This would involve setting new financial goals by simply adding an anticipated percentage to both expenses and revenue.

However, while static budgets offer a sense of stability and predictability, they also pose significant uncertainty when it comes to effective cost containment. In this era of rapid change and dynamic market conditions, relying solely on static budgets can prove detrimental to the financial performance and long-term viability of businesses.  

One of the primary downfalls of static budgets is their inherent inflexibility. Static budgets are typically set at the beginning of a fiscal period based on historical data and assumptions about future trends. Once established, these business budgets remain fixed throughout the specific period, regardless of any changes in market conditions, consumer behavior, or internal dynamics. This lack of flexibility makes it challenging for organizations to adapt to unforeseen circumstances or capitalize on emerging opportunities. Static budgets often fail to capture the full complexity of business operations and the dynamic nature of costs. They are typically based on broad categories and averages, overlooking the nuanced drivers inherent in cost structures. As a result, static budgets may not accurately reflect the actual costs incurred during the specific period, leading to discrepancies between budgeted and actual operating expenses. This discrepancy undermines the effectiveness of cost containment efforts, as managers may lack visibility into where liabilities are being incurred and how they can be controlled effectively.

Relying solely on static budgets for cost containment can lead to complacency and inertia within an organization. When business budgets remain fixed, there is a tendency to overlook the importance of active cost monitoring and management of business finances.  Over time, such oversight can gradually erode profitability and competitiveness, posing a significant challenge to the organization's long-term success. It is crucial, therefore, to adopt a more proactive approach that embraces a dynamic budgeting process and continuous cost evaluation to ensure sustained financial performance and a competitive edge.

Poor budgeting can have a significant and detrimental impact on an organization's financial performance, particularly in terms of cost control. One immediate consequence of outdated budgeting is reduced profitability, which can lead to financial hardships and hinder growth opportunities. When budgets are not accurately aligned with strategies and lack the necessary flexibility, organizations may unknowingly and unnecessarily lose funds, resulting in eroded profit margins and threatening the overall sustainability of the business. Organizations must prioritize effective budgeting practices to ensure financial stability and long-term success.

Without dynamic budgeting processes, cost containment efforts may be hindered when cash flow changes can’t be accurately reflected using 3-statement modelling. Organizations lacking dynamic budgeting struggle to track cash flow fluctuations coming straight from changes to the profit and loss and balance sheet, making it slow to adjust inefficiencies or overspending. Consequently, the inability to track cash flow dynamically in the budgeting process makes it challenging for organizations to contain costs effectively and maintain financial performance.

The importance of budgeting  

Understanding the benefits of budgeting, and using the right budget processes and systems is crucial for obtaining accurate information and making real-time business decisions to effectively control costs. This means using integrated software for budgeting that lets you bring together all financial and operational data.

At Phocas, we recommend budgeting software that gets everyone on the same page to enable you to effectively steer the business. One in which budgeting and forecasting are connected.  

Every team and relevant stakeholders can collaborate easily with the prebuilt workflows, and the driver-based functionality provides one place for sales forecasting, demand planning, and headcount management. It’s a living financial compass and it’s what you need to steer towards business success.

Armed with an integrated view of finance and operational data, you can now choose your types of budget process for cost containment.  We recommend Zero-based budgeting and/or Activity-based Budgeting as a starting point to think about for your business.  

Zero-based budgeting  

Zero-based budgeting is a business budgeting method where all expenses must be justified for each new period, starting from a "zero base." Unlike traditional incremental budgeting, which adjusts previous budgets by a percentage, zero-based costing requires every expense to be evaluated anew based on current needs, priorities, and performance objectives. This approach promotes accountability, transparency, and efficiency in resource allocation.

It's effective for cost containment because it instills accountability. Managers must justify every expense, eliminating wasteful spending and encouraging disciplined budget planning.

Additionally, zero-based budgeting enhances transparency by requiring a detailed review of all fixed costs and variable costs by line item, making it easier to identify inefficiencies and areas of overspending.

It fosters efficiency by promoting continuous improvement. Managers are encouraged to streamline processes and seek out cost-saving initiatives, driving sustainable improvements in financial performance.

Lastly, zero-based budgeting offers flexibility to adapt to changing business needs, ensuring resources are allocated to their highest-value uses. According to McKinsey, ‘when implemented effectively, Zero-Based Budgeting can lead to a significant reduction of 10 to 25 percent in Sales General & Administrative costs, often within just six months.’

Activity-based budgeting  

Activity-based budgeting offers a strategic advantage in cost containment by aligning budget allocations directly with the activities driving costs within an organization. Unlike traditional budgeting methods that rely on historical data and broad category allocations, Activity-based budgeting provides a granular understanding of cost drivers and their associated activities.  

By identifying and prioritizing high-impact activities, organizations can allocate resources more efficiently, focusing investments where they yield the greatest returns. This targeted approach allows you to identify your road map and your financial objectives while enhancing cost containment by eliminating waste, reducing non-value-added fixed and variable expenses, and optimizing resource utilization across all facets of the business.

An activity-based budget promotes accountability and transparency by linking budgetary decisions to specific activities, empowering managers to make informed choices, and ensuring that resources are allocated effectively to support strategic objectives. Activity-based budgeting enables  business owners to enhance financial performance, achieve greater cost efficiency, and maintain a competitive edge in today's dynamic business environment.

Just like Captain Nemo taking on a massive squid with his trusty axe, we've armed you with the right budget resources you need to tackle costs. Leveraging integrated real-budgeting and forecasting software, along with a combination of budget methods like Zero-based or Activity-based budgeting, will help you improve your cost control, decision-making, and financial performance and navigate your 'Nautilus' towards smooth waters. 

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Written by Katrina Walter
Katrina Walter

Katrina is a professional writer with experience in business and tech. She explains how data can work for business people without all the tech jargon. She is always on the look out for new ways data is being used by business people to know more and be sustainable.

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