We have been talking about an annual planning process. It began two postings ago when we talked about laying out three to five strategic initiatives aimed at moving the company forward. Then with our last posting, we began a 2-part discussion on what some call a “budget,” but what we prefer to call a “profit plan.” Part 1 dealt with the revenue side of things. How do we forecast what we expect to sell next year? Now we’ll deal with the cost side of things. We need a spending plan that anticipates what we expect our costs to be next near. If you’re interested in our discussion about projecting costs, please continue reading Profit Plan (Part II) below.
Don’t produce a budget. Map out a Profit Plan. (Part 1I)
The basic problem we see with forecasting the cost side of the business is people trying to take shortcuts in the name of being expedient. Most shortcuts create two problems:
- They can rob you of the level of detail you need to spot waste, inefficiency, or irregularities.
- If your Plan starts to falter, they can make it difficult to analyze what’s going wrong, and even more difficult to figure out how to fix it.
Here are a few examples of shortcuts you should not take.
Bad shortcut #1
Breaking down all our sales and expense projections by month is a real pain. Can’t we make do with just the annual numbers?
Nope. You’ll want to break down everything by month so that when your actual financial statements are available each month, you’ll be able to compare them to your Profit Plan. If your Plan is made up of only annual numbers, you may not realize it’s off target until it’s too late in the year the do much about it.
Bad shortcut #2
We know what our overall Cost of Goods is as a percentage of sales. Can’t we just use that instead of calculating a separate Cost of Goods for each of our products or service lines?
If you’ve got multiple products or service lines, each with its own unique Cost of Goods structure, you’ll need to know how much of each you expect to sell, and then do a separate Cost of Goods calculation on each. Otherwise, if your Cost of Goods starts going out of whack, how will you know which of your products or service lines is the culprit?
Bad shortcut #3
Do we really have to analyze our fixed costs. After all, they are “fixed,” right? Can’t we just use last year’s costs as a percent of sales and go with that?
No, we can’t. Our fixed costs (usually referred to as SG&A or Overhead) are “fixed” only in the sense that we have to pay them no matter what. Even if we’re having a dismal sales month, we still have to pay salaries, utilities, bank debt, etc. But these so-called “fixed” costs do change. We may hire new office people or grant salary increases to existing employees, the lease agreement for our office space may have a rent escalation clause, some of our vendors might put through price increases, etc. Besides, if we just base our spending on historical trends, we eliminate opportunities to improve . . . to eliminate waste and improve efficiency.
Throughout this process, for both revenue and expenses, you should be recording assumptions for each line item, i.e. “We plan to put in an across-the-board 5% price increase in April,” or “We expect our energy costs to be flat.” During the year, as you compare your actual results to the results you expected in your Profit Plan, you’ll be looking for variances or deviations. When you find them, if they are significant, you’ll ask yourself, “What the heck were we thinking when we forecast that number?” If you recorded your assumptions properly, they will remind you what you were thinking. If the assumption is flawed in some way, then you may have to make a correction to your Profit Plan. But if the assumption still seems valid, then we apparently failed to execute on that particular item and we’ll need to find out if there’s some corrective action we can take to get back on track.
Now for the tough part. You’ve projected your sales and expenses for next year, so now you can see your projected profit. If that number meets your expectations, then good, we’re done. But if not, you have a choice to make: you can either except the profit level the Plan projects (even though it’s lower than what you expected); or you can go back to the Plan, tweeking it here and there to produce the profit result you want. The danger here is that your sound business judgement gets replaced by hope and unreasonable optimism, and the tweeks you make are nothing more than wishful thinking. Obviously, you want to avoid that.
In summary of this posting and the previous two postings:
- Begin building your annual plan by laying out the three to five strategic initiatives you expect to implement to move the company forward during the coming year.
- Forecast sales and expenses for the coming year to produce a Profit Plan, noting all the assumptions you make during that process.
- As you set your strategic goals and build your Profit Plan, be as inclusive as possible. The more people you are able to involve in the process, the more support you’ll have when the new year starts and it’s time to execute your plans.
- Throughout the process, immerse yourself in the details of your business, and avoid shortcuts that may undermine your annual plan’s usefulness as a valuable management tool.