The psychology of financial budgeting
There are few words in the English language that conjure feelings of scarcity and deprivation than the word “budgeting”.
Our lizard brain responds to the term budget in the same way it responds to the word diet — utter dread.
Budgeting, like dieting, sucks because it requires determination. It requires us to be disciplined with our spending habits. It forces us to think twice about spending and adopt the mentality of penny pinching. It often requires a change in habits.
I was surprised to learn that 3 in 4 Australians regularly maintain a personal budget. Unfortunately, this doesn’t translate to the business world. My best estimate is that less than 5% of Australian SMEs maintain a business budget.
Why? I believe it has a lot do with human behaviour.
But, before we deep dive into that, let’s start with the basics.
What is a budget?
A budget is a plan. It’s a tool used to quantify an organisation’s business strategy over a time period. A budget is typically built for a 12 month period, designed by your accountant or CFO.
The process of building a business budget entails the following:
— Developing estimates of future sales and cashflow
— Developing estimates of future expenses
— Developing estimates of capital expenditure and financing arrangements
— Summarising these estimates into a profit and loss, balance sheet and cashflow statement. This is referred to as a 3-way budget.
It’s important to note that a budget is a living, breathing document. It is not a spreadsheet that is dumped in the archive folder, ready to be revived when your bank or VC requires it.
Rather, a budget should be reviewed every month. Actual performance should be compared against the current month budget. This analysis allows Management to measure progress against the organisation’s goals. This assessment guide’s Management’s actions for the future.
The benefits of budgeting
There are a range of benefits that come with maintaining a financial budget.
1) Quantify what is and isn’t working
The process of comparing actual results against a budget allows Management to assess how the organisation is tracking to it’s goals. It can act as a data point to address what tactics are working, what isn’t working and what should be tweaked.
2) Predict the future
A well prepared and thought-out budget can help to predict future financial performance. By assessing projected sales, expenses and cashflow it allows Management to make proactive decisions. For example, if budgeted sales are expected to be lean due to the holiday season, financing facilities can be pre-approved to fund any working capital shortfalls.
3) Align management to organisational goals
Keeping staff and management aligned to the goals of the organisation is hard to do without a pace car, a goal. A budget can provide this set of quantifiable targets they can strive towards. It’s an accountability tool.
4) Understanding the business drivers
Beyond visibility, the value of developing a budget is in the process. It will help Management understand the business drivers. For example, revenue should be broken down to number of leads, average sale value and conversion rate.
Number of leads X conversion rate % X average sales value
By getting granular with the business drivers, Management can begin to manage and measure daily and weekly activity. This allows Management to augment decision making with data — rather than making decisions based on gut feel.
Why we suck at budgeting, and how to change it
If there are clear benefits to keeping a financial budget, why doesn’t every business have one? A few factors:
1) Management hasn’t grown up.
When a business is starting up — it’s likely the founding team are small enough to have a pulse over operations. In this instance, budgeting doesn’t need to be too sophisticated.
However, once the business grow beyond say 5 employees, things get more complicated. As tasks are delegated and outsourced, the founder loses control and oversight over day to day operations. Without a mechanism to monitor and track performance, things can quickly get out of hand. Relying on gut instinct just won’t cut it.
2) Chiefs verse Indians
Budgets and strategies are typically dictated by the board and Management team. These ‘Chiefs’ at the top aren’t necessarily the individuals driving the actual performance of the business. Rather, it’s up to the employees, the Indians to make change happen. There is a balance between setting an aspirational yet realistic budget. An imbalance can either foster a lazy culture (too easy to smash the budget) verses un-motivating one (the budget is impossible to hit!).
There are two tactics to overcome this:
i) Involve your team in the budget process — getting group buy-in will help with accountability.
ii) Set a realistic budget — balancing aspiration and being realistic is more of an art than science. We’ll explore how to navigate this in our next blog post.
3) Like dieting, budgets are hard to stick to.
Budgeting, like dieting, can be perceived as a fad. We’re all familiar with diets that promise a quick and easy solution to weight loss with minimal effort. From the grapefruit diet, to the tea diet, to the cabbage diet.
All ‘hacks’ designed for shallow, short-term results.
Business budgeting, unfortunately, is comparable.
‘Strategy days’ are set by the leadership team in the big corporate with the goal to inspire and instil confidence with employees. The CEO speaks with bravado, unveiling the strategy and plan for the next 12 months. Everyone is left feeling inspired and excited for the future. The following week, business continues as usual, as if nothing happened.
Six months later, Management raise concerns that we’re slightly behind budget, but assure us it’s ok…there are still six months to make up the shortfall.
Ten months later, Management scoot around the office in a panic, screaming we’re drastically “behind budget”. In sheer desperation, they resort to hacks. Plan B strategies to make up the short fall. Funky accounting adjustments are raised to make the numbers look better.
These practices just compound problems. They’re not only cheating stockholders, but also themselves.
This is unfortunately we’re most leaders go wrong. The game of business is a sprint, not a marathon. And like anything that’s worth doing, there are no shortcuts. You must do the work.
Budgets are a goal setting tool
Studies suggest that to create discipline, we must focus on the process, rather than the end goal. Focus on the ritual of being accountable to the budget framework and make tweaks as we go — rather than leaving it to a mad sprint to the finish line.
A budget is the antidote to our impulsive and emotive lizard brains. A tool to keep us focused and disciplined to our long-term strategic goals.
The budgeting process
In our next blog, we’ll explain you how you can build a simple and robust budget for your business. Included is a complimentary budget template designed by entrepreneurs, for entrepreneurs.