Setting Your Annual Budget in Economic Uncertainty

Many economic indicators are on the verge of danger. Experts in economic recovery and restructuring in their region four-fifths of the recession; three quarters predict major changes in industry structure. Companies enter a period of planning and budgeting in a time of great uncertainty. This “wouldn’t it be” period could be a harbinger of a major setback.

Ordinary budgeting cannot cope with these times. Executive austerity, that is, cutting a few places and hoping for the best, will not be enough. The guidance of this approach can be dangerous. Action is needed right now.

Our firm’s long and deep experience in helping troubled companies shows the results of waiting. This gives us four critical lessons that can keep companies safe and that every company should apply immediately. Because even companies that seem solid this year are navigating dangerous waters amid a fog of uncertainty.

Organize your financial alert system.

Many companies realize the danger too late. One reason is that business unit budgets track returns and costs on the profit and loss balance sheet and not cash flow or balance sheet items. While these three are linked at the very top of the company, profit and loss holders should see them too. They will likely be the first to notice slowing orders, increased inventory, or delayed collections, but they effectively ignore the cost of capital and rarely look at the balance sheet as a source of funds or savings. As a result, they often overlook the broader meaning of what they see.

Redesign your planning, as well as your monthly and quarterly reviews, so anyone who manages a business unit can see all three views of your business: profit and loss, balance sheet and cash flow. Understand where your incomes are most vulnerable and what a sudden drop in demand will lead to. What costs are at risk? Which assets will be affected? What indicators will alert you?

Maximize cash production.

Cash is essential in tough (and even awkward) times. This becomes even more important as interest rates rise. So, include working capital management initiatives in your plans. Cash generation improvement projects include things like changing the way you manage debts and receivables, reducing inventory and speeding up distribution. Be clear about how much will be saved when and by whom, then actively monitor progress and related cash generation.

You can generate cash by reducing credit limits. Additionally, review what’s on your balance sheet. Is it better to own or rent a truck? How many of your IT assets have not migrated to the cloud yet? By outsourcing assets or processes, you can turn fixed costs into variable costs. This allows you to increase or decrease your cash needs.

Create possible scenarios.

What does a mild, moderate or severe setback do to your business as a whole or to each part of it? Be specific. Where are you most affected by inflation? A drop in demand? A supply chain nuisance? What actions would you take in these situations? Who should take these actions?

Create three scenarios and three responses. These will be leverages you can use anytime. The first is the lever that is easy to pull. This includes actions that save cash without long-term harm, such as hiring and travel freezes, cuts in discretionary spending, and cuts in some marketing spending.

The second lever is used when a setback is quite deep or long and is more painful. These are steps such as postponing new product launches or cutting capital expenditures other than maintenance.

Finally, prepare a crisis scenario. This scenario includes what to do if the business suddenly falls into trouble, such as layoffs, restructuring, or selling assets or a business. Whenever you can, do the same for your opponents. Where might a setback hit them the hardest? What can they do?

Prepare these scenarios now, even if you don’t need them. That way, if things go wrong, the question is not what to do, but when to act. You should also preset indicators for when to use each leverage. This will make it harder to ignore the warnings. Then use monthly and quarterly reviews to not only monitor performance for planning purposes, but also re-validate the baselines of the plan. In a rapidly changing environment, what was true six months ago may no longer be true. That doesn’t mean you’re wrong, but that things have changed.

Do not draw conclusions from last year.

You need an active view of costs and revenues. Use a zero-based budget understanding to understand how the business is driving value and where it isn’t delivering. Most companies use this approach only occasionally to clean up the debris that accumulates in ordinary expenses. However, it is a powerful competence that can reveal opportunities for structural change and workload reduction.

Treat revenue forecasts with similar rigor. Most budgets place more emphasis on costs than revenues. (This is why CFOs regularly overlook the volatility of their sales team estimates on the expense side that they can never tolerate.) To fix this, first focus on key customers who you need to have candid and regular conversations with. As you should on the expense side, determine how, when and by whom each change in income will be made. These are evidence of the numbers you can best spot on the plan. Follow these projections in monthly and quarterly reviews. You can add more value to revenue planning by analyzing customer profitability. Usually 20 percent of customers actually make you lose money. A healthy company should regularly review and prune its client list.

Taking action now through these four measures will prepare you for tough times. Also, if you institutionalize them, they will take your planning and budgeting process to a much higher level than most companies achieve. They will provide a budget designed for action, not just control.

In this way, even if there is no recession, you will have created a stronger, more courageous business and created a financial buffer that is ready to be used in times of crisis.