A budget can be used as an instrument of control. It’s better to use a budget to learn faster and perform better.
It’s a Guideline, Not a Rule
A budget isn’t a contract. It doesn’t tell how you should run your business. Rather, a budget is a summary of your best guesses as to how your business will perform over the coming months. Used well, a budget helps you more quickly recognize when reality varies from your expectations. The quicker you can identify points of divergence, the quicker you can consider making changes.
Jen Nord on Using a Budget Productively
I recently had the opportunity to speak with our friend Jen Nord about how to use a budget productively. You would expect her to advocate the use of a budget. After all, Jen is a CPA and a CMA. However, using a budget isn’t an article of faith with her. As usual, Jen understands the practical value of this foundational management tool. For her, it’s all about learning, adaptation, and performance relative to your goals for your business.WHAT'S A CMA?
The OODA Loop
Let me explain how the correct use of a budget can accelerate your learning. First, consider the “OODA Loop”, a model of learning:
- Observe means to collect relevant, valid information about a situation.
- Orient means to make sense of what you have observed.
- Decide means to commit resources to an action based on your updated understanding.
- Act means to execute and, as a consequence, generate additional data.
The originator of the OODA Loop, John Boyd, experienced (through the crucible of air combat) how rapidly cycling through the OODA Loop with initially imperfect information can yield better results than waiting for better information. In other words, the iterative ready-fire-aim approach is often better than ready-aim-aim-aim…fire.
That can be true in the business world, too. When you are doing something novel, there is little valid information upon which to base your decision. Success favors those who are willing to act in order to generate valid data and can adapt their behavior based on evidence. If you cycle through the OODA Loop quickly, you’ll learn faster and perform better.
A budget makes variances between the results you expected from your actions and actual results more visible.
In order to observe something, you must first be able to see it. A budget makes variances between the results you expected from your actions and actual results more visible. The faster you can see a variance, the faster you can re-orient, decide on a new course of action, execute, and improve your performance.OODA LOOP
Budgets, Forecasts, and Predictions
Prediction is a fool’s game. However, forecasting – the exploration of possible futures – improves your capacity to respond quickly and effectively to the unpredictable. In the context of financial management, Jen considers forecasting to be the process through which you decide how to allocate your scarce time and resources.
A budget, on the other hand, is a monitoring tool. Although not a prediction, a budget is an explicit description of your best, informed guess of how your company is most likely to perform over the coming months.
Develop a Budget from the Bottom-up. Use a Budget from the Top-down.
Jen recommends building a budget from the bottom-up. That is, start at the detailed expenditure level and then aggregate those details into workable categories. For instance, you might create a monthly budget for web hosting, web application subscriptions, and WordPress plugin fees and then aggregate those expenditures into a single parent category called “Website Expenditures”.
It’s only by making our assumptions explicit that we make them testable, refutable, and amendable.
“Precision” isn’t the primary reason for building a bottom-up budget. Rather, the process provides you with the opportunity to make your assumptions clear. It’s only by making our assumptions explicit that we make them testable, refutable, and amendable.
Periodic comparisons of your actual results with your budget should be done with the summary numbers. Monitor your Website Expenditures rather than your web hosting fees. Otherwise, you risk drowning in superfluous detail.
Once you observe a significant variance between your actual results and your budgeted expectations, you can drill down into the detail to learn more. Having prepared your bottom-up budget, you’ll be better able to decide upon effective action for improved performance.
Avoid Too-frequent Updates to Your Budget
We tend to hate inconsistencies. We’ll engage in convoluted behaviors in order to resolve them (at least in our own mind). So, it’s not unusual if you feel the desire to update your budget in order to reflect the impact of variances. Try to resist the temptation, though.COGNITIVE DISSONANCE
As Jen points out, if you update your budget frequently, your budget devolves into a copy of your retrospective financial statements. To point out the obvious, your budget doesn’t add any new information in that case.
Your budget was a guess. It was bound to be wrong. It is by highlighting your errors that you have the opportunity to cycle through the OODA Loop faster to learn faster and perform better.
Embrace the variances! Your budget was a guess. It was bound to be wrong. It is by highlighting your errors that you have the opportunity to cycle through the OODA Loop faster to learn faster and perform better. Hiding the variances through constant updates to your budget may be palliative, but it will inhibit learning.
More From Jen Nord
We speak with Jen regularly on how to make effective use of information derived from your accounting system. Here are links to other such conversations: