Budgeting

What is budgeting?

Budgeting (also budget planning, German Budgetierung) refers to the process in which a company translates its planning into binding target values for a given period. The budget usually applies to the coming financial year and is broken down by month. For each area of responsibility, such as sales, product development or administration, the budget specifies what revenue is to be achieved, what costs and investments may be incurred and how many positions may be filled. In a similar way, a sports club determines in its annual budget before the season starts how much each department may spend and what contributions must come in to cover it.

A budget is both an authorisation and a target: it permits spending up to a certain amount and commits to a result. It is adopted by the management. In companies with financial investors, the annual budget often additionally requires the approval of the shareholders' meeting, an advisory board or the investors, as provided for in the shareholders' agreement or the rules of procedure. The basis is the multi-year financial model, from which the budget derives the first plan year in detail. It is prepared, tracked and explained in controlling.

Budget process: top-down, bottom-up and counter-current

In the top-down method, the management sets revenue, earnings and cost targets from the strategy and the financial model. This is quick and keeps the budget in line with the plan that investors know, but it creates little ownership in the departments. In the bottom-up method, the departments plan their own volumes, positions and costs. The result is detailed and supported by those involved, but often contains reserves, and the total not infrequently exceeds the financial framework.

The counter-current method is therefore widespread: the management sets the framework, the departments plan in detail, and in one or more rounds of reconciliation the two views are brought together. In practice, the process usually begins in the fourth quarter so that the budget is adopted before the financial year starts. In technology companies, the largest block is usually the personnel budget, which is derived from the headcount plan, the list of all existing and planned positions with start dates and salaries.

Methods of setting the budget

• Incremental budgeting (Fortschreibung): prior-year values plus or minus a percentage. Quick, but carries forward every earlier misallocation.
• Zero-based budgeting (Nullbasis-Budgetierung): every item is justified afresh without reference to the prior year. Laborious, therefore usually only for individual cost blocks or at longer intervals.
• Driver-based budgeting: revenue and costs are derived from a few volume and price variables, such as new customers per month, average price, positions and salaries. If an assumption changes, the budget recalculates in a traceable way. Software companies with recurring revenue often use this method.

The budget over the year: budget-versus-actual comparison and forecast

A budget steers only if it is compared with actual figures on an ongoing basis. This is done by the monthly budget-versus-actual comparison (Plan-Ist-Vergleich): it sets the actual values from the monthly closing against the budget values, quantifies the variances and explains their causes. In practice, it is also called a target-versus-actual comparison (Soll-Ist-Vergleich); in cost accounting, that term more precisely means the comparison with a plan converted to the actual volume. Without the accruals and deferrals of the monthly closing, it compares plan values with random booking positions.

New expectations for the remaining months belong not in the budget but in the forecast, the continuously updated projection. The budget remains unchanged as a reference so that variances remain measurable across the whole year. The gap between forecast and budget shows what gap to the annual target is likely to remain. Budget, actual and forecast appear side by side in the monthly management reporting to the management, advisory board and shareholders.

Budget, financial model and liquidity planning

The financial model calculates over several years and scenarios. As integrated financial planning, it links earnings, balance sheet and liquidity planning, so that every assumption affects earnings, assets and cash at the same time. The budget is the first annual extract of the base case, broken down by month, cost centre and responsible person. It usually follows the logic of expenses and income. Liquidity planning translates it into cash receipts and payments and takes account of payment terms, VAT, investments and financing.

For growth companies, the budget is also the basis of liquidity management. It sets the monthly cash consumption (burn rate) and thus how long the available funds last (runway). If actuals deviate, the variance flows into the forecast and from there back into the financial model.

Worked example: budgeting using the counter-current method

A software company with 50 employees prepares the budget for the coming financial year in the autumn. The base case of the financial model provides for EUR 6,000,000 in revenue and EBITDA (earnings before interest, taxes, depreciation and amortisation) of minus EUR 600,000. A position costs the employer an average of EUR 6,000 per month, salary and social security contributions combined.

• Cost framework of the management (top-down): 6,000,000 plus 600,000 = EUR 6,600,000
• Personnel for the 50 existing positions: 50 × 6,000 × 12 = EUR 3,600,000
• Six new positions from January, as reported by the departments (bottom-up): 6 × 6,000 × 12 = EUR 432,000; personnel in total EUR 4,032,000
• Total requests: personnel 4,032,000 plus marketing 1,500,000 plus other costs 1,384,000 = EUR 6,916,000, which is EUR 316,000 above the framework
• Reconciliation, first step: the six positions are filled in stages, two each on 1 April, 1 July and 1 October. This gives 2 × 9 + 2 × 6 + 2 × 3 = 36 person-months, so 36 × 6,000 = EUR 216,000 instead of EUR 432,000. The personnel budget thus falls to 3,600,000 plus 216,000 = EUR 3,816,000
• Reconciliation, second step: the marketing budget falls by 100,000 to EUR 1,400,000; total 3,816,000 plus 1,400,000 plus 1,384,000 = EUR 6,600,000
• Monthly personnel values: January to March EUR 300,000 each, April to June EUR 312,000 each, July to September EUR 324,000 each, October to December EUR 336,000 each, EUR 3,816,000 in the year

Only the monthly values make the budget steerable. For May, the budget-versus-actual comparison expects personnel costs of EUR 312,000, not one twelfth of the annual figure of EUR 318,000. If a hire is delayed, a timing variance arises, which the forecast picks up for the remaining months while the budget stays unchanged. In the following year, by contrast, the six new positions are incurred in full at EUR 432,000. This carry-over belongs in the financial model, otherwise the second year looks cheaper than it is.

Budgeting from the perspective of investors and buyers

In due diligence, the review before entry, investors compare the budgets and actual figures of past years. Planning accuracy, that is, how closely earlier budgets were met, shows how reliably the management assesses its business and determines how much trust the new financial model receives. After the investment, the budget becomes the yardstick of reporting: information rights require regular budget-versus-actual comparisons, and the investor update explains the variances. In a sale process, buyers set the budget of the current year against the months achieved so far; an ambitious budget that is missed after only a few months weakens the seller's negotiating position.

Distinction: budgeting, forecast and budget-versus-actual comparison

• Budget-versus-actual comparison: measures actuals against budget values and explains the variances. Budgeting sets the yardstick, the budget-versus-actual comparison applies it month by month.
• Forecast: the continuously updated expectation for year-end or for a rolling window of usually twelve months. The budget stays fixed, the forecast moves with every new month.
• Integrated financial planning: links the planned income statement, planned balance sheet and liquidity plan over several years, usually in the financial model. The budget details its first year and makes it binding.
• Controlling: the function that prepares, tracks and explains the budget. Budgeting is one of its instruments, alongside budget-versus-actual comparison, forecast and cost accounting.

Common mistakes

• Incremental budgeting without review. After a few years, nobody can justify why an item has its amount.
• Budget as an entitlement to spend. The worry of being cut the following year leads to spending at year-end with no discernible benefit.
• Budgeting only costs. Without a revenue and earnings target, a budget is merely a permission to spend.
• No responsible persons. An item without a named person responsible is steered by no one.
• Annual values spread evenly across months. If start dates, seasonal patterns and annual payments are not reflected, the budget-versus-actual comparison shows variances that stem only from the distribution.
• No reconciliation with liquidity. An approved budget can endanger solvency if payments fall due before receipts.
• Two plans without a reconciliation. If the budget deviates from the financial model presented to investors without the difference being explained, doubts arise about both.

Frequently asked questions

Does a rolling forecast replace the annual budget?

As a rule, no. The rolling forecast looks ahead twelve or more months on an ongoing basis and shows where the company is heading. The budget remains the fixed yardstick against which the management and investors measure target achievement. Some companies dispense with fixed budgets altogether; in investor-financed GmbHs (German limited liability companies) this is rare, because approval reservations and information rights are tied to an adopted budget.

May the budget be changed during the year?

Only exceptionally and by formal resolution, for example after a funding round or an acquisition that fundamentally changes the framework. New expectations without such an occasion belong in the forecast. If the budget were adjusted every time, the variances would disappear, and with them the steering information.

Who adopts the budget in an investor-financed GmbH?

The management, often subject to the approval of the shareholders' meeting, advisory board or investors. How far this reservation extends, for example also for overruns above certain limits, is regulated by the shareholders' agreement and the rules of procedure of the management.

Must the budget match the financial model from the funding round?

Not necessarily, but every deviation should be justified and reconciled. Investors measure development after the round against the plan presented; a budget that deviates from it without explanation silently shifts that yardstick.

The Roemer Capital view

The financial model with which we accompany companies into a funding round covers at least three years with a base case, a cautious case and an optimistic case. We derive the budget for the first year from the base case so that, after the round closes, investors can measure against exactly the plan that was presented to them.

As part of our fractional CFO services, we set up the monthly budget-versus-actual comparison, explain variances in the investor update and calculate their effect on the runway. Planning accuracy demonstrated over several quarters is an argument in the next round that no pitch deck can replace.