Drafting and managing your budget
In the previous article., Finance for Technologists: Part 1 - The budgeting process, I discussed the intimidating process of presenting a budget to the company board and the type of questions each executive may ask you. With those questions in mind, we take a closer look at what you need to consider when drawing up a budget and then using your budget wisely to successfully deliver a project.
Prioritisation of budget items
The budget process should not be looked at as fearful or mundane exercise. It’s a tool to quantitatively validate your thoughts and strategy and how you intend to spend the money. It can highlight areas where you may be overspending or underspending or areas you haven’t considered at all. Each line item must speak for itself with easily understandable notes and dates and prioritised using MoSCoW prioritization (must have, should have, could have, won’t have). Budgeting is also a process of negotiation and compromise. You won’t get everything you want so prioritization is critical to discussions.
Drawing up a budget
When drawing up the budget, there is the temptation to double or triple the budget estimates and then cut back to what you actually wanted. The problem with this approach is that the people sitting on the other side of the boardroom table are no fools and will likely see through this approach when picking apart the costing of each line item. Your budget should rather reflect the vision of your plan. Each line in the budget should be aligned to your plan and how this is going to make or save money or reduce risk. Ensure you include contingency clearly for unknown but anticipated expenditure. Then the budget will require tweaking rather than completely rehashed.
Approaches to funding a project
There are broadly two ways of funding the project, either Operational Expenditure (OpEx) or Capital Expenditure (CapEx) or combination of the two. An accountant can elaborate on the benefits of one over the other as there are tax and financial management and reporting implications. Further, there is a growing trend to finance significant portions of IT projects through OpEx instead of CapEx because of pay-as-you-go cloud solutions. OpEx via cloud solutions also has the advantage of being scalable with business needs. CapEx usually is long term and results in an asset, for example, a new website and servers which have value for the next 5 years. OpEx is shorter term, for example, the cost to operate the company on a day to day basis for the year.
Considerations behind allocating budget
Despite your snappy presentation to the board and defending each line item, you will likely only be granted part of the funding and your natural response is “How can the execs be so naïve?!” You planned everything meticulously and cutting back seems ridiculous. This is where you should see it through their eyes and that you may not be privy to all the factors behind the decision. If this endeavour is going to require too much capital investment or they just do not have the appetite for exposing the company to too much risk and the company does not wish to seek funding through one of several financial instruments (eg: additional shares, loans or bonds) then something must give. The board has to cut their cloak according to their cloth and prioritise spend of which yours is only one of many put forward. Simple financial management ratios (see addendum) will highlight very quickly that the company has potentially overextended itself and that could result in some challenging discussions with the shareholders.
Managing budget spend
With the budget allocated, you have the responsibility to manage it. It’s imperative you do not overspend. Going back to the board to grovel for more money (CapEx extension), whether your fault or not, is not a pleasant experience. The reverse is true: don’t fail to spend the budget allocated. I’m talking about saving money by negotiating a better deal or selecting a cheaper option, I’m talking not doing anything with the allocated budget. Negligent underspending is extremely poor management of resources. The company has opted to invest its hard-earned money, resources, and reputation in your capable hands to use wisely instead of investing in 1 or more alternative options, or reducing spending in other areas. There is an opportunity cost for investing in your proposal instead of alternatives.
Critical to successful management of your budget is managing cash flow (cash going out versus cash coming in). Many very profitable companies have gone bankrupt because they have not managed the flow of cash in and out of the company and ended up not having the cash to service their debt. Further, you won’t have a big bucket of cash to tuck into at will. The budgeted amount may be funded entirely via operational revenue that is brought in to the company rather than dipping into its cash reserves or investment. So plan accordingly. One scenario where management of cash can be particularly tricky is in consulting - do you hire in the anticipation of work to be better prepared and trained or do you hire only once the work is signed? The views of IT and Business are completely juxtaposed as to how to approach this point and compromises need to be made on both sides such that the team is adequately prepared without putting the company at risk. It’s a tough call because you don’t know with absolute certainty when the work is going to kick off and when the new hires will start making money rather than eating away at the cash reserves. The money spent with the new hire on the bench is wasted and it can end in disaster very quickly if not managed carefully. I’ve personally experienced scenarios where projects with firmly established start dates are suddenly delayed, project budgets slashed or canceled altogether, all for perfectly valid reasons beyond my control.
Warning: Trap of hidden costs
A final word of warning: be careful of hidden costs that you may not have taken into account. For example, have you accounted for sundry roles such as account manager, system administrator for deployments, seniors assisting juniors, initial environment setup costs, bug fixes, QA to write up test scripts, drafting reports, customer meetings? These are just a few examples of some of the sundry items which can easily come along and destroy a well thought out budget and plan. Business does not necessarily understand these hidden or unforeseen costs and will give you a tough time when you have to present this unexpected expenditure.
In closing managing finances is very complex and IT should give Business credit for the tough job they have on their hands. Business decisions may not always seem rational in the eyes of IT, but Business have to weigh up where to invest the company’s money and attention and which opportunities to go for and which, no matter how promising they may seem, let slip by in order to ensure the longevity of the company at that point in time. Before judging a business decision as irrational, always remember best intentions and that you may not be aware of all the factors behind the decision. Money after all does not grow on trees
Addendum – some useful terminology
- Balance sheet – the financial position of the company at a given point in time. It comprises what it owns (assets) vs what it owes (liabilities) and the value of the business to its shareholders (equity). Also known as the statement of financial position. The basic formula is Total Assets = Total Liabilities + Shareholder Equity
- Income statement – reports the company financial performance over a given period in terms of revenue and expenses where net profits are income fewer expenses. It reflects how the company has earned and spent its money during this period. There are 2 parts to it; the regular everyday operating expenses and revenues generated from that (operating items) and revenue and expenses from non-operating activities such as investments or sale of assets. Also known as Profit and Loss or P&L Statement.
- Cash flow statement – analysis of the cash moving in and out of the company over a given period. It comprises operating activities, investing activities and financing activities. “Cash is king” as the old saying goes. If you run out of cash you can’t pay your staff or your creditors and you will be in serious trouble.
Balance sheet ratios
These balance sheet ratios are used to measure the risk in a business. There are many ratios to analyse the financial position of a company, 2 of which I mention below. If these ratios show a decline, the company may be in for trouble:
- Current and quick ratios – how easily can the company service its debt through liquid assets, i.e., how easily can the company meet its debts without going bankrupt in the event of a financial crisis?
- Debt to equity ratio – how much debt does the company have versus the shareholder equity. This determines how much money a company can borrow and at what rate and gives an indication of the company’s ability to survive over a long period
P & L statement ratios
Similar to the balance sheet ratios, the income statement ratios derived from the P & L statement focus on revenues and expenses and how effective the company is at turning revenue into profit.
- Margin: ratio of the income from sales vs the cost of producing goods
- Net operating profit (EBITDA) - how much profit did the company make taking into account the revenue less cost of producing goods and all associated operating and administrative expenses but ignoring interest, tax, depreciation and amortisation.
These ratios look at how efficiently the company makes money (revenue) from its assets and how effective it is in converting sales into cold hard cash. An example is the Return on Assets which shows how much profit is made versus the value of your company’s assets.DuPont Analysis is a common method of measuring the performance of a company in terms of its use of assets based on their gross book value.