CEOs and CFOs of growth-oriented companies seek answers to the same difficult questions every budget season. How aggressive should we be when budgeting?
We want to grow as fast as possible and make exciting new investments. But if we set goals that are too high, we are more likely to fall short of our budget, lose credibility with the board and investors, and find ourselves strapped for cash.
We know that it is safe to promise low and exceed targets, but if we set targets too low, we will grow slower, leave the door open for competitors, and ultimately reduce the company’s value in the market.
So where do we find the balance between these two extremes?
In our article, we will examine the “Optimum Budget” approach that “Bessemer Yatırım” created based on their experience with hundreds of growth-oriented companies they have worked with.
This approach basically involves categorizing companies’ Budgets and Forecasts by probabilistically determining them and adding the rate of target achievement as a new dimension in addition to target setting.
For example, a company:
- Set an aggressive budget that you can hit with a 30% chance of success, or
- You can prepare a more probable budget that you can hit with a 50% chance of success, or
- He/she can prepare a more conservative budget that will achieve his/her goals with a 70% chance of success.
As a result of comparing the prepared budgets with the actual ones periodically, statistical and proportional data is kept about the company’s risk approach while preparing the budget, and this ratio provides an important idea for the budgets to be prepared in the next period.
For example, if the company has been able to meet its budget in 5 out of 10 quarters so far, it can be said that the budget for this company has a 50% probability level.
In addition, each budget consists of three main sections with different probabilities, and the probability assessments of these sections must be made separately.
- Sales and Marketing Plan
- Revenue Budget and Revenue Forecast
- Cash Budget and Cash Forecast
Sales and Marketing Plan
Targeted Revenues consist of two main sections: “New Revenue” and “Recurring Revenue”
“New Revenues” are the lifeblood of companies focused on rapid growth. Rapid growth requires new customers, new marketing channels, new distribution partners, and new products. But all of these come with risks.
Still, companies need to invest in these risky targets. We recommend companies that want to grow to “dream big and make reasonable investments to make their dreams come true” despite all the risks.
With good planning, many companies achieve impressive goals, while some companies achieve unimaginable success with a little luck and hard work.
Of course, there are companies that hit all the obstacles along the way: We often come across negativities such as delays in customer purchase or payment plans, unsuccessful marketing attempts, unsuccessful or delayed new product launches.
We still encourage companies to set high targets. Even if they miss their budgets, they will still achieve much better results than they would with modest budgets. As a result, targets for “New Revenues” should be budgeted with a 30% probability level.
In addition, when managers set budget quotas for sales personnel, each target should be published with a 10% increase in the main budget items. This 10% extra budget will be a protective measure in case some sales personnel fall short of their targets.
“New Revenues are the lifeblood of companies focused on rapid growth.”
Income Budget
In his book High Output Management, Andy Grove points out that the chance of success in any highly competitive, optimized and well-measured field is 50%, and he specifically cited professional sports as an example because of its similarity to business life: “The probability of winning any high-level competition is 50%.”
As in sports, when making an Income Budget, targeting should be based on a 50% probability.
To achieve this, first create a good Sales and Marketing Plan for New Revenue and add an air cushion for unpredictable delays and nasty surprises. Then add targets for existing customers that are easier to predict and plan how to increase those sales.
While determining all these targets, work should be carried out according to the 50% probability of meeting the budget.
Cash Budget
“The CEO’s job is to dream big, and the CFO’s job is to keep cash above zero at all times.”
While the main task of the CEO is to dream big and achieve those dreams, the main task of the CFO is to keep cash above zero level at all times.
Expense budgets are easier to estimate and maintain than income budgets, but there may be surprises in this section as well. Extra R&D or operational costs may arise for important customers, sudden job changes for personnel in critical positions may impose unexpected severance pay and new recruitment costs, changes in technology may create adaptation costs to new technology, or unexpected increases in production may increase periodic labor costs.
A revenue budget created with a 50% probability, combined with possible surprise expense items, will create too much risk for CFOs and CEOs who cannot accept cash falling below planned levels, at least not critical levels.
In this case, the CFO’s best choice would be to keep “Reserves”. The reserve item will act as an air cushion for unexpected expenses in the budget or shortfalls and delays in income. The reserve item that the company will set aside should be enough to bring the probability of realization of the cash budget to at least 70%.
This reserve amount and protective probability level will provide confidence to the CFO, CEO, board of directors and shareholders, ensuring that the company has the cash resources it needs to survive and thrive.
The combination of the income budget, the expense budget and the cash budget constitutes the main budget. This budget is the main structure approved by the board of directors and where the company explains the comparison results in its monthly and quarterly reports.
Forecasting
Once the master budget is approved and published, it never changes. But the business world changes quickly.
Companies that have adopted a budget culture create updated Forecasts based on their approved master budgets at least every 3 months. In cases where conditions change rapidly, many companies are forced to publish monthly forecasts. Some companies, such as Oracle, publish weekly forecasts with strict budget tracking policies.
When creating a forecast, figures updated with new information should be used, just like in budgeting, with probabilities of 30 percent / 50 percent / 70 percent. For example, after the first quarter (Q1) is completed, the actual data for the Q1 period and targets updated with new data for Q2-Q4 are determined and a new forecast is published.
Q4 Optimism Fallacy
Companies generally set acceptable and achievable targets for Q1 and Q2 in their budgets, and budget a reasonable increase in Q3 that is appropriate for the first half of the year. In Q4, they aim for big jumps in revenue items and collections. New investments, recruitment, and marketing expenses are budgeted at the beginning of the period, and these investments are expected to be realized by the end of the year.
Companies that create their budgets with this logic may fall into the mistake of thinking that they achieved 75% success in three of the four periods, even if they experience serious deviations in Q4 because they met their budgets between Q1-Q3.
This is a deceptive trap for managers and board members. The most important revenue items of the year are generated at the end of the year, and these revenue items also create potential customers for sales in the following year. In order to claim a successful budget period, companies must keep their Q4 budgets at least at the level of their Q1-Q3 budgets.
Conclusion
When creating a budget, CFOs and CEOs should evaluate various budget scenarios, their probabilities of occurrence, and their outcomes together.
This won’t be easy to achieve at first, because CFOs are paid to be pessimistic and CEOs are paid to be optimistic. CEOs will be almost certain that a budget with a 70% probability will be met, while CFOs will be much more conservative.
After this stage, Board Members should be consulted to get approval for probability estimates.
Even before budget contingencies are prepared and presented, it will save time to request a survey of board members regarding their contingency expectations. Don’t be surprised if there are very different contingency expectations among board members. If this is the case, it will be necessary to organize a preliminary meeting to determine the most appropriate contingencies for the company.
References
Recognizing Probabilities In Budgeting And Forecasting
