Tag Archives | decision making

Why Prepare a Budget?

Do you need to take an umbrella to work today?

Without a trusty weather app or friendly meteorologist, it would be difficult to know the answer. Fortunately, you probably have one of these tools to help you make an informed decision.

The CFO/Controller is the meteorologist for the business.  It’s your job to help the company decide when, and if, you’ll need an umbrella.  How do you do this? Prepare a budget.

prepare a budgetWhat is a budget?

A budget is an estimate of income and expenses within a given amount of time. It contains economic goals, boundaries, and limits on expenditures of the organization.

Why Prepare a Budget?

So, why prepare a budget? By creating a budget, you’ll be able to hold the company accountable for its expenditures, reduce costs, and prepare for a worst case scenario. It serves as a measurement tool that can visually illustrate if you have enough cash to operate or to grow.

The steps in the budgeting process are:

  • Prepare the budget
  • Negotiate and agree on the budget
  • Monitor the budget

Prepare a Budget

First, you as the financial leader must choose what type of budgeting method you want to use. There are two main types of budgets: zero-based budgets and traditional budgets. While zero-based budgeting allows you to re-examine all of your costs, traditional budgeting is more user-friendly.

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Typically, prepare the annual budgets before the fiscal year begins. This window of preparation helps facilitate execution.  Early decision-making will provide boundaries within which the company must abide. Oftentimes, if you don’t prepare budget ahead of time and create it on the spot, then arguments and internal issues begin to arise. You can avoid disputes when executing a budget by preparing early.

During preparation, it’s important to focus on fiscal targets. Fiscal targets are are goals for specific financial categories. These could include profit, debt payback schedule, operating expenses, projected borrowing requirements, etc. By laying out these goals, you’ll be better equipped to prepare a budget that will allow negotiating and finalizing of the budget to go smoothly.

Optimistic Budgets

prepare a budget

As a reminder, an overoptimistic budget can result in late payments and disorderliness in regards to keeping in compliance with the bank. There are several ways you could be overoptimistic in your budget, the major one being you are not projecting your sales correctly. If you’re a couple cents off, it’s okay.  A budget should be seen as a “set of guidelines, not rules, based on the best forecasts at the time but always open to amendment as circumstances warrant” (Accounting at Your Fingertips, p. 332).

To reduce the chances of creating an overoptimistic budget, it’s important to go back to the basics. By focusing on the economics of your business, you’ll not only create a realistic budget, but you’ll be better able to project future growth.

(NOTE: Want an easy tool to analyze your company’s economics? Download the Know Your Economics Worksheet to make sure you’re pricing for profit!)

Negotiate and Agree on the Budget

As with most things in business, negotiation comes into play.  The purpose of negotiation is to allocate resources according to your targets and policies with everyone’s best interest in mind.  However, fiscal policies should provide the framework for budget formulation. Make sure that you consider your company’s economics when structuring the budget.

During this negotiation process, it is vital for you as the financial leader to maintain the meeting as a negotiation rather than let the meeting turn into a bargaining session. Bargaining results in a win-lose situation where the goal is to get as many of your points on paper over another person or department. It may drive the process, but it is not effective. Often, the outcome of bargaining is inefficient resource allocation.

By comparison, negotiation is all about a group of people working towards one goal. Part of this goal should be to comply with fiscal policies and targets.

Monitor the Budget

So much time and hard work goes into creating a budget, yet so many companies fail to utilize the budget. The purpose of a budget is to measure operational efficiency and performance issues.

The efforts of budgeting should be focused on improving revenue forecasting or projecting. A budget is useless unless utilized in a dynamic manner. While budgeting provides the short-term execution plan, forecasting allows you to take historical data to measure the reality of success in executing your budget. You’ll be better able to allocate resources to the right departments.

(Check out the 5 tools that you might not be using but should be implementing along side your budget.)

When you link the budget and the forecast, you’ll be more equipped to monitor the budget.  Contrast this with a static budget that is often useless after the first month. It all starts by knowing your unit economics and then assessing your economics to judge whether they are working for your company.

To ensure that your budget is built to achieve your business goals, make sure to start with the basics. Find out more about how you could utilize your unit economics to add more value to your organization by clicking the link below.

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prepare a budget, Why Prepare a Budget

There are many methods you can use to improve productivity in your company. Click here to download a PDF of 10 Ways a CFO Can Improve Productivity.

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10 Ways to Improve Productivity

improve productivity, Ways to Improve ProductivityThe new year is well under way and many of us are working with new, leaner budgets.  When we were developing these plans at the end of 2014, it seemed completely realistic that we could cut costs while maintaining our current sales volume.  Now that the holiday buzz has worn off and harsh reality has dawned, how do we actually make it happen?

10 Ways to Improve Productivity

The first, and most obvious way, is to get a handle on any costs that may have gotten out of whack.  Most of us were running pretty lean after the last economic downturn, but costs have a way of creeping back up when the economy improves and companies begin focusing on growth rather than survival.

Another thing to take a look at is pricing. Do key decision-makers understand the economics of your business and are prices set based upon these economics?  If you’re bidding jobs or setting prices on a 30% margin but your fixed costs are running 40%, then you clearly have a problem.  When was the last time you looked at your pricing?

You’ve made sure costs are under control and prices are in line with business economics. But what else can you do?  The answer is simple:  you seek out ways to improve productivity.  While the answer may be simple, the actual process of improving productivity isn’t always straightforward or intuitive.  We put together a tip sheet listing 10 ways to improve productivityClick here to check it out.

Best of luck to you in the new year!  If you have any tips or thoughts to add, please leave a comment below. Improve your pricing – and your profits– by downloading the free Pricing for Profit Inspection Guide.

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Opportunity Costs in Your Decision-Making

businessman at crossroadsHave you had to make an important decision and you kept weighing the alternatives, trying to decide which choice was more worthwhile? We all make important life decisions every day. We tend to focus on the benefit of our first choice and not the benefits of the next best choice. An opportunity cost is the value of the next best alternative.

Opportunity Costs

Opportunity costs apply to many aspects of life decisions. Often, money becomes the root cause of decision-making. If you decide to spend money on a vacation and you delay your home’s remodel, then your opportunity cost is the benefit living in a renovated home. For time management, if you decide to spend time working late at the office on an important project, your opportunity cost is the benefit of spending quality family time at home. In business, opportunity costs play a major role in decision-making. If you decide to purchase a new piece of equipment, your opportunity cost is the money spent elsewhere. Companies must take both explicit and implicit costs into account when making rational business decisions.

Example of Opportunity Costs in Decision-Making

For example, Bill Gates dropped out of college. Yet, he ended up creating one of the most successful software businesses in Microsoft. His opportunity cost was the benefit of a college education at Harvard and a stable, successful career working for someone else. However, his entrepreneurial drive led him to choosing the route of becoming a self-starter and entrepreneur. While most people who drop out of college do not become billionaires, it was different for Bill Gates. The opportunity cost of staying in college and working for someone else didn’t have enough value compared to his dream of becoming an entrepreneur.

Life decisions require the two following things:

Your opportunity costs are not the same as the person sitting next to you. The true cost of one choice is the cost of what you give up to get it. The more choices we have in society, the more you have to give up by choosing one thing over another. As long as you are content with the result of your decision, whether you think about what you gain or lose, you can live a successful life.

Learn how to apply concepts like this in your career with CFO Coaching.  Learn More

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Sunk costs: How should they affect your future business decisions?

sunk costsWhether in business or in personal life, we can all look in the past and say that we’ve been in situations where we’ve wasted money, time, or energy on things that did not end up being worthwhile. Was there a moment during that situation when you thought about backing out before you sank even deeper?  The sunk cost dilemma refers to the decision between investing additional resources into an uncertain situation, or abandoning the sunk costs. In this blog, we are answering the question: how should sunk costs affect your future business decisions?

How should sunk costs affect your future business decisions?

There are controversial views whether sunk costs should affect your future business decisions and be considered in the decision-making process. Take sunk costs into account to prevent the mistakes of future sunk costs. But they should not be the main reason why you stay in a downward-spiraling predicament. Humans have the inherent tendency to deny failure. We fear facing defeat. However, by not facing those failures head on, we run the risk of making the same mistakes in the future. Those who say to disregard sunk costs ignore that sunk costs are a critical aspect of improving your business.  Once you learn what NOT to waste resources on and when to walk away, then you can spend resources on profitable and rewarding things.

Example of Sunk Costs

For example, I met a business owner who had spent a significant amount of resources into a new start-up business. Bit it had been falling in a downward spiral for months. He heard of a new business opportunity that could be implemented quickly and proven very profitable.  The business owner asked for my advice. He felt like it was wrong to walk away from the all of the money, time, and energy invested into his business venture.

My first reaction was the following… If his justification for not letting go and moving on to new opportunities was the notion that what he had invested made the venture worth something, then he would acting irrationally and unrealistically.  Although his business may have had some value, the worth of the business would not necessarily improve if he spent even more money, time, or energy into it.  If he decided to stay in his current business solely based on his attachment to the sunk costs, he would lose out on a higher return on his resources with the new business opportunity.

Next time you are in a similar business predicament, be rational and realistic.  Make smart decisions not solely based on your attachment to the resources you have invested until that point in time. Learn from the past mistakes of sunk costs and improve for success in future business opportunities.

Click here to read more about sunk costs. Also, learn how you can be the best wingman with our free How to be a Wingman guide!

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Variable vs Fixed Costs

See Also:
Absorption vs Variable Costing
Semi Variable Costs
Sunk Costs
Marginal Costs
Average Cost

Variable vs Fixed Costs Definition

In accounting, a distinction is often made between the variable vs fixed costs definition. Variable costs change with activity or production volume. In comparison, fixed costs remain constant regardless of activity or production volume.

All Costs

In accounting, all costs are either fixed costs or variable costs. Variable costs are inventoriable costs. That means accountants allocate fixed costs to units of production. Then they are recorded in inventory accounts, such as cost of goods sold. Fixed costs, on the other hand, are all costs that are not inventoriable costs. All costs that do not fluctuate directly with production volume are fixed costs. Fixed costs include indirect costs and manufacturing overhead costs.

Comparing Fixed Costs to Variable Costs

When comparing fixed costs to variable costs, or when trying to determine whether a cost is fixed or variable, simply ask whether or not the particular cost would change if the company stopped its production or primary business activities. If the company would continue to incur the cost, it is a fixed cost. If the company no longer incurs the cost, then it is most likely a variable cost.

Variable vs Fixed Costs Examples

To further help explain these costs, find a couple variable vs fixed costs examples below.

For example, if a telephone company charges a per-minute rate, then that would be a variable cost. A twenty minute phone call would cost more than a ten minute phone call. A good example of a fixed cost is rent. If a company rents a warehouse, it must pay rent for the warehouse whether it is full of inventory or completely vacant.

Other examples of fixed costs include executives’ salaries, interest expenses, depreciation, and insurance expenses. Examples of variable costs include direct labor and direct materials costs.

Variable vs Fixed Costs and Decision-Making

When making production-related decisions, should managers consider fixed costs or only variable costs? Generally speaking, variable costs are more relevant to production decisions than fixed costs.

For example, if a manager is deciding between keeping production levels constant or increasing production, then the primary factors in this decision will be the variable or incremental costs of the production of additional units of output. It would not be the fixed costs related to the operations that cannot be altered and will not change with the level of production. Therefore, in most straightforward instances, fixed costs are not relevant for production decision, and incremental costs, or variable costs, are relevant for these decisions.

If you want to utilize your unit economics to add more value to your organization, then click here to download the Know Your Economics Worksheet.

variable vs fixed costs, Variable vs Fixed Costs Examples, Variable vs Fixed Costs Definition

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SWOT Analysis

See Also:
Porter’s 5 Forces of Competition
Core Competencies
How to Write an Action Plan
How to Turnaround a Company

SWOT Analysis

The SWOT Analysis – an acronym standing for Strengths, Weaknesses, Opportunities, and Threats – assesses a company’s competition in the desired field or market. This analysis serves as an excellent tool for decision-making, either for personal use or from a business standpoint.

Business SWOT Analysis: Planning, Performance, and Evaluation

The purpose of a SWOT analysis, from a business point-of-view, is to organize a proper business strategy around the internal and external factors that affect one’s business. Existing or older businesses may use a SWOT analysis to predict or proactively adapt to the environmental changes pertaining to their business. New or starting businesses may use this analysis to plan ahead before their actual business plans to assess potential road bumps or advantages they can use.

How to Complete a SWOT Analysis

When mapping out a business strategy with a SWOT analysis, you first look at the four elements in your company: Strengths, Weaknesses, Opportunities, and ThreatsStrength and Weaknesses are considered internal factors that might affect a company. These are characteristics, rather than physical elements surrounding the business, such as profitability or shortages. The Opportunities and Threats are considered external factors. These are the physical elements such as network or competition.

SWOT Analysis

Benefits of a SWOT Analysis

With the SWOT Analysis you can:

  1. Analyze the current situation of a company.

    SWOT shows the leaders of a company how realistic their situation is. With the simple grid system, people can visualize and organize their thoughts. This list may be pages long, but with the SWOT Analysis, you can easily distribute and interpret the information easily.

  2. Provide different perspectives when executing a decision.

    When completing a SWOT analysis, a leader of a company is forced to consider all different types of potential aspects that affect the company, not only what they see on a regular basis.

  3. Simplify; SWOT does not require extensive technology or payment during completion.

    You can do this method on a computer, piece of paper, or dry-erase board. And it’s free – straight from your mind.

Limitations of a SWOT Analysis

In comparison to many other types of business analysis, SWOT may not be as ideal because:

  1. The method is not as detailed.

    The SWOT analysis only has four factors, compared to other types of analysis which have seven or eight different factors. The method is useful with analyzing an idea or small maintenance in business planning. But you may need other methods to be paired with this analysis in order to get a full, detailed plan.

  2. You have to make a new SWOT every time you make a change.

    When updating a plan or making  a new decision, you have to consider all four factors in the SWOT analysis that might alter your previous factors. We recommend updating your SWOT analysis at the end of every financial year to project future losses, or when you don’t meet your goals.

  3. Subjectivity.

    In any decision-making process, the data collected must be reliable and un-biased. It is easy to misinterpret or over-represent your own strengths and opportunities versus weaknesses and threats when not done in a group setting.

Download your free External Analysis whitepaper that guides you through overcoming obstacles and preparing how your company is going to react to external factors.

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Sunk Costs

See Also:
Sunk costs: How should they affect your future business decisions?
Variable vs Fixed Cost
Replacement Costs
Joint Costs
Service Department Costs
Ten In-House Secrets for Reducing Your Company’s Legal Costs
Capital Budgeting Methods

Sunk Cost Definition

What is sunk cost? A sunk cost is a cost that has been incurred and cannot be recovered. The money is spent. In accounting, a sunk cost is a type of irrelevant cost. When facing a potential project or investment, a manager must only consider relevant costs and ignore all irrelevant costs.

When a manager is considering a particular decision, relevant costs are the costs that are incurred if the decision is made and irrelevant costs are the costs that are incurred whether or not the decision is made. A sunk cost is not a relevant cost for decision making.

Whether a cost is relevant or irrelevant depends on the decision at hand. A cost may be relevant to one decision and that same cost may be irrelevant to another decision. A sunk cost, however, is always an irrelevant cost.

Sunk Costs Fallacy

The sunk cost fallacy is when someone considers a sunk cost in a decision and subsequently makes a poor decision.

An example of the sunk cost fallacy is paying for a movie ticket, finding out the movie is terrible, and staying to watch anyway just to get your money’s worth. When you find out the movie is terrible, you should make a decision whether to sit through the bad movie or to do something more meaningful with your time – the price you paid for the ticket should not affect your decision. The ticket price is a sunk cost.

Another example of the sunk cost fallacy is paying for an all-you-can-eat buffet, eating until you’re full, and then going back for more just to get your money’s worth. When you are full, you should decide whether you want to eat more or to stop eating – the fact that you paid for unlimited food should not affect your decision. The price of the buffet is a sunk cost.

Sunk Costs Examples

Let’s say a company spent $5 million building an airplane. Before the plane is complete, the managers learn that it is obsolete and no airline will buy it. The market has evolved and now the airlines want a different type of plane.

The company can finish the obsolete plane for another $1 million, or it can start over and build the new type of plane for $3 million. What should the managers decide? Should they spend that last $1 million to finish up the plane that’s almost done, or should they spend the $3 million to build the new plane?

At first glance, you may think the company should just finish the old plane. It’s only another million bucks and they already spent $5 million. But in reality, the five million is irrelevant. It is a sunk cost. The only relevant cost is the $3 million dollars. The managers should consider whether or not to spend $3 million on the new plane, and nothing regarding the old plane should affect the decision.

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