This is CFO Secrets. The weekly newsletter that turns controllers into CFOs.

10 Minute Read Time

In Today’s Email:

• 🔫 Bullet proof budgets

• 💯 100 Management Ratios in 300 pages

•  🤨 What is Cousin Greg upto?

Before we start. It appears a number of you didn’t receive the last couple of newsletters. This was caused by technical issues I don’t understand, but I’m told it’s fixed now. If you missed them; you can find them here:

30 April FP&A Overview: What happens when FP&A goes wrong in a $100bn business

6th May Long Term Plan: From Strategy to Numbers: How Make Bold Financial Commitments

Anyway … let’s get into it.

THE DEEP DIVE

Art or Science? How to Build a Winning Budget in 6 Steps

This is Week 2 of 6 in a series on FP&A.

“Yes but which one is the ACTUAL F-ING BUDGET, young man.”

I felt humiliated, patronized and useless all in one go.

It was my first experience in front of a VP of Operations. A veteran of the industry. He was the classic grizzled old operator. Old enough to be my Dad (+ another ten years). Veins popping out of his head. Booming voice.

Here I was explaining his budget problem to him.

And I was doing a sh*t job of it.

I’d done what I thought was a good piece of work. There was a gap between the bottom up budget build and the top down expectation.

I’d broken both down so we could compare at a line item level to see where the gap was. Printed on a big piece of ledger paper.

But I’d confused him with the idea of ‘two budgets’

The right analysis, but the wrong output, using the wrong language and most of all … the wrong audience.

I learned three valuable lessons in that moment:

1. It doesn’t matter how good the background work is, if the output isn’t good.

2. Not everyone speaks business school bullsh*t finance lingo. I better get multi-lingual, and quick.

3. Budgets are about engaging non-finance stakeholders. It’s a business process facilitated by finance. Not a finance process.

A better way to present it would have been:

“Tony, here’s your budget. It’s $3m short of where you need it to be. So we need to close this $3m gap. I’ve got four ideas, I’ll take you through. Can we agree that neither of us leave this room until we’ve agreed a plan together?”

Same underlying message, different presentation.

Better alignment.

And as I said last week, financial plans are all about alignment. Especially budgets.

So this week we’ll dive into budgets, and how to achieve that alignment.

We’ll start from the basics.

What is a budget?

A budget is a detailed financial plan you write down for the year ahead.

How is it different to the Long Term Plan?

Last week, we talked about the Long Term Plan, which is the big brother of the budget. So let’s start by understanding the differences.

Many of the principles are similar. As the budget is a more detailed single year version of the LTP.

The key differences:

What is the budget used for?

The budget is a tool used to drive behavior towards better financial performance

Finance are the custodians of the process, but it is a business process, not a finance process. Many budget processes I’ve seen fail on this premise alone.

A good budget will act as a center of gravity for business performance.

It will also be the central reference point for the finance team for the next 12 months.

And there are many practical uses:

• align stakeholders on an operating plan

• provide reference point for cost control

• performance manage department / business heads

• ensure KPI targets tie into financial plan

• basis for annual bonus plan

• anchor for variance analysis

• guidance for external stakeholders

• and many more

When is the budget built?

Straight after LTP process.

Normally starts 3-5 months before start of new year. And will take most of the time up to the new year.

What is the output from the budget process?

This is difficult to answer, and will be different dependent on the businesses. But there are a few central principles:

• A detailed financial budget loaded into the system by cost center and account code

• A summary of the annual operating plan in a format that gets used by the senior team

• Cascade of the deliverables of the budget across the organization

What are the steps in a budget process?

1. Set top down expectations

2. Build bottom up budget

3. Identify and resolve budget gap

4. Wedding vows moment

5. Analyze and approve

6. Lock & Load

Let’s go deep into each:

1. Set Top Down Expectations

Writing a budget is a lot easier if you know what the answer should be before you start.

‘Top down budgeting’ is the napkin math that gives you that answer.

The north star for the budget.

Not for the whole financial statements, just the crucial metrics. For example; Revenue, EBIT, Capex, Free Cash Generation, (or whatever is fit for your business).

It is also helpful to break this down into the operating units in which the budget gets reviewed.

This is a good way of making sure each operating unit is working to metrics that give you the answer you need in total.

So how do you get to what those numbers should be?

Remember, the Long Term Plan (LTP) we talked about last week?

Year 1 of that LTP is the start point for the top down budget.

Are there any reasons to change the plan? Any new information that has emerged since the LTP plan concluded?

Let’s use an example.

A group with 3 business units plus a corporate center:

One business unit (in this case C) has under-performed since the LTP was set.

As a result revenue expectations for next year are now down $300m. This puts a hole in the budget meaning that EBIT will now be $100m lower next year.

The top down budget process allows you to reset expectations to cover this gap.

Firstly decide what you want to solve for. In this example, we assume the priority is to solve the original total Free Cash Flow Target for the Group.

Even if it means lower revenue and EBIT.

That may not be the correct thing to do (business specific). But is an assumption for this illustration.

How do we solve the $100m gap created by EBIT performance in Business Unit C? It’s a big gap, so no one thing solves it. In the above illustration:

• Business Unit C loses $50m of their capex budget

• Business Unit B gets pushed for another $100m of revenue, with $25m EBIT

• Business Unit A has $25m of discretionary R&D spend removed.

We have been able to solve our free cash flow back to the same start point, but the overall shape is now quite different.

This is why this part of the process must happen first. You need Business Unit A, and Business Unit B to be working towards more stretching targets.

If you communicate this later, it will be too late. You’ll end up swallowing the bad news in C, without A & B delivering their extra stretch.

This should all be done in consultation with the Business Unit Presidents and CFOs.

This can be emotive, and may need the Group CEO & CFO to mandate a position.

I have seen a BU president fired who refused to sign up to a target stretch that the Group CEO felt was reasonable.

As CFO your role is to make sure that any gaps are super transparent, and everyone is clear on what is needed.

This part of the process should be quick, but in practice there are a lot of politics.

Once this is done …remember what you have isn’t ‘the budget’, but the signpost for what the budget should be.

2. Build the Bottom Up Budget

You might argue if you already know the answer, what’s the point in doing anything else.

Well, you do have the answer, but only for a small number of metrics, and at a high level.

Now the time for the real work building the ‘bottom up budget’. This is when the assumptions come up through the business, to see if they add up to that top down expectation.

The output of this part of the process is useful.

But the process itself is even more useful.

It’s the time when the team pauses to determine what is the plan for next year:

Do you want to discount to grow sales with that small but exciting new customer? Or hold firm on margin and risk market share?

Should you drive volume before investing in capacity, or the other way round?

That new Business Development Director needs to deliver some concrete sales this year. How much should you task them with?

Should you increase planned maintenance to increase asset life in older locations?

Do you invest in new laptops as planned or let those three year old Dells roll over another year?

There will be hundreds of questions like this. Far too detailed for the LTP, but now is the time to answer them.

And then there is the question of ‘when’? As in which month (or even week) will all this happen in.

This will dictate the shape of the budget.

A budget process has a large number of stakeholders. It needs real discipline to keep the process together. Many of the principles for this are the same as the LTP (which we covered last week) but on a bigger scale.

Robust project management is important. Each part of the budget needs a business and finance owner. Review meetings pre-scheduled and formats communicated. Weekly project calls to ensure progress mintained.

I said last week that Excel is fine for managing an LTP.

That is not the case for a budget.

The level of detail you are building a budget at means it can be unwieldy in Excel.

Compare a LTP build at ‘BU Level’ for 5 years, over 20 financial statement captions, vs a Budget built at 200 GL codes, for 52 weeks, across 100 profit / cost centers.

The output is 2,000x in size.

And there needs to be a piece of logic or calculation behind each datapoint (even if it’s zero). Some of those calculations will be circular, multi-stepped and with complex logic.

That is a lot of complexity for Excel.

In some businesses it will be fine, others will need an FP&A tool.

There are plenty out there, I won’t recommend any, even though I’ve been offered money by some providers to do so. Do your own homework.

Having a well built model, and good quality, simple input templates is crucial to the process.

When the budget comes back together it happens at lightning speed. You need to be able to trust your technology and models.

Some parts of the P&L will be dependent on other parts, so managing that circularity is a challenge. You need to find the right way to do this.

Here’s an example of how you could build it up:

• Identify factor that constrains growth first; sales or capacities (most often sales)

• Gather the assumptions for that factor; e.g. sales

• Then gather assumptions for the other factor; operational activity

• Iterate between sales and operations until you have an answer both agree on

• Set variable cost & expenses. Based on relationship with sales and operational activity assumptions

• Set fixed expenses using zero based budgeting. I.e. start at zero allowing only essential fixed expenses in

Once you have the basis of a bottom up P&L that hangs together as a whole, you can move on.

3. Identify and Resolve Budget Gap

So you now have your top down expectation, and a first draft of a bottom up.

Here’s the big question… do they balance?

Easy one.

No. Never.

They never ever balance.

Not even for a minute.

And it’s always in one direction. The bottom up almost always falls short of the top down expectation.

Why?

Could be one or more of many reasons, but here’s one that is always true.

The bottom up will have suffered from ‘compound prudency.’ Lots of people involved, means a bunch of little safety nets. And they add up (and often multiply).

Budgets are full of politics. After all they set the targets for next year on which people get compensated.

There are two ways to knock your target out of the park; 1) do a great job, 2) get a comfortable target.

Your job as CFO is to mediate the answer to a sensible outcome.

In a big business there could be several layers of management involved in a budget.

Each will have their own mini ‘top down’ expectation for the people beneath them.

So the whole budget is full with little tensions between top down and bottom up.

Think of it like the net in a hockey goal. The tension has to be right at each intersection. Not to much, not too little. But enough to keep it together and tight as a whole.

But it must get resolved. Ultimately (as Tony told me) there can only be one budget, and that is the bottom up budget.

Much like the LTP, resolving these gaps could need several iterations. I find it good to maintain a ‘budget audit trail’ so you can track different versions of the bottom up budget.

During this part of the process the focus is on the big year on year drivers;

1. Risks. Things that will worsen profit year on year.

2. Initiatives. Things that can be done to improve profit.

3. Investments. Discretionary investments that will worsen profit in year. But for the good of the long term health of the business.

4. Tasks. An allocated, but not identified initiative

5. Contingency. Unallocated prudency (to allow for one or more assumptions / component to miss)

Often the game here is to protect the investments, and contingency. They are both discretionary (but necessary). As the easiest thing (and finance can be guilty of laziness here), is to chop out investments or contingency to deliver a profit gap.

Showing you want to protect investments can be very motivating for stakeholders. It gives you leverage to trade with stakeholders to trade to the outcome you need.

A great FP&A cycle is all about making sure you hand off from one part of the process to the next.

Now we have gone from a 5 year high level LTP, to a detailed annual operating plan, and resolved all the gaps along the way.

That means at the lowest level of detail an individual maintenance engineer has a $50k annual budget. And we can be confident that is part of a coherent plan. One that adds up to the right EBIT number in total, all the way back up to our LTP.

4. Wedding Vows Moment

We covered this last week, but it’s even more important in the budget than it is in the LTP.

A moment where all stakeholders agree to ‘get married’ to the budget, and the assumptions within it. This should be a joint and several collective commitment.

Bind the team around the plan.

Til death do us part.

5. Analyze and Approve

Now you have a budget the business is aligned to, is time to take it back into finance, and finish it off.

First thing is to convert the bottom up budget into a full calendarized Income Statement, Balance Sheet and Cashflow.

Then you can start analyzing it.

Waterfall charts are great here. Understanding movements for Revenue, Gross Margin, EBIT, & Free Cash Flow. We’ll cover analysis and charting in more depth in future newsletters.

Building those waterfalls at the right level is crucial. Ensuring that the budget can is understood between risks, initiatives, investments, tasks and contingency. Broken between Full Year Effects & Part Year Effects (as we explained last week).

Once you have rationalized the budget in total for the major metrics.

You should test some other areas, where budgets can be vulnerable:

• Hockey sticks. Budgets where all the task / difficult stuff is back loaded to the end of the year. This is a common and inappropriate way to resolve budget gaps. The challenge should be loaded evenly through the year.

• Wraparound. Checking that the opening weeks of the new year in the budget look reasonable. In the context of actual performance at the end of the old year. I got caught with this a few times. If the business blows out its budget in the first couple of months, everyone looks at finance for setting a stupid budget.

• Phasing. Check that the key metrics look sensible throughout the year year on year. And deliver the quarterly results you are looking for.

Once you are happy with the budget in all its glory. You should take it through the exec and board approval process (like the LTP last week).

Use a simple 10-12 page slide deck that tells the story of the budget.

6. Lock & Load

Once you have a board approved budget it’s time to lock and load.

That means loading it into the systems and reporting at the appropriate level. Feeding it into KPIs and incentive schemes.

Being ready to report against it in the new financial year.

Making sure you communicate out the final budget in the right form to all stakeholders is vital.

You want no ambiguity on what each individual has to do to deliver their part of the budget.

Anyway, that’s how you run a budget process.

And make sure you end up with a granular annual operating plan, that everyone feels married to. AND keeps your corporate objectives in tact.

BOOK CLUB

Key Management Ratios by Ciaran Walsh is a great book which really gets under the skin of how to measure a business.

It covers headline Income Statement, Balance Sheet & Cashflow measures. But also goes deeper into other areas such as acquisition performance, operational metrics, and even financial integrity.

It very elegantly covers a lot of ground (at a high level) in 300 pages or so.

For non-finance, this is a nice overview into a comprehensive set of finance issues. And for finance pros there will be plenty of areas that make you pause to think.

FEEDBACK CORNER

A review of last week’s edition:

Read CFO Secrets… get promoted. Might have a new strapline : )

POACHED GREG

Greg’s Season 4 heel turn is feeling a bit like Daenerys in the final Game of Thrones series, or Nate the Great in Season 2 of Ted Lasso.

Intrigued whether it’s just light relief, or he has a major hand left to play.

Anyway …

That’s all for this week. As always you can find me here on CFO Secrets, Twitter, & LinkedIn.

Budgets were fun. Next week forecasts. Warning: will contain controversial views.

Until next time…

Stay Crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend. But I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need to make the right decisions.