Popular planning approaches compared
Many companies’ approach to budget setting is all wrong.
They make a percentage adjustment or estimate every line item.
Neither extreme is optimal. Here is one framework you can use instead:
1) MINIMIZE: Percentage adjustments to the prior year
2) OPTIMIZE: Zero-Based Budgeting
3) MAXIMIZE: Driver-based planning
Let’s dive in.
Percentage Adjustments
Taking the prior year’s numbers and adjusting them up or down based on a specific percentage is the easiest way to set a budget. But it’s also the least effective.
That’s mainly due to two reasons, 1) it doesn’t take changes in underlying business drivers into account, and 2) it has unwanted side effects, such as people wasting money at the end of the year just to get higher budgets in the next one.
Zero-based budgeting
You start with a blank slate and add only those cost line items that meet specific effectiveness criteria. Those could be linked to the associated revenue impact or other relevant KPIs. But it’s a time-consuming exercise. It takes so many resources in terms of time and leadership attention that it’s only worth it in rare circumstances.
Instead, you can optimize this approach to get similar results with a smaller time investment. Instead of starting with a blank slate, use last year’s expenses as a starting point. Then, review major expense items to decide whether to keep or cut them.
Driver-based planning
You begin by looking at your business drivers and then linking them to associated costs (you don’t consider expenses first as you do with Zero-based budgeting).
For example, one of your business drivers may be the number of visitors to your online store. Let’s assume you need to increase that metric by 10% to make your revenue targets.
Next, you use your return on investment analysis to determine how much you need to spend in Advertising to get there.
This approach has the significant advantage that it prepares you for surprises. We all know revenue never comes in precisely as planned months in advance. With driver-based planning, you know what to do if the output is lower or higher - you adjust your inputs (advertising dollar etc.) according to the relationship you determined during the planning process.
That’s why I recommend using driver-based planning as much as possible.
When can’t you use it? If you don’t have enough data to determine the relationship between inputs and outputs. And for costs that aren’t directly linked to business drivers, such as certain overheads.
If you’d like to learn more about FP&A, I offer help in three ways:
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