Budget Planning

What is Dynamic Budgeting?

By ITR Economics on August 29, 2023

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ITR Economics

ITR Economics is the oldest, privately-held, continuously operating, economic research and consulting firm in the US.

Guest article provided by FocusCFO.

Unlocking the Power of Dynamic Budgeting for Your Business 

In the world of business, static plans are more often than not a recipe for disaster. Consider budgets, which are traditionally seen as fixed, unchangeable plans. Unfortunately, this approach is fundamentally flawed, mainly because the assumptions and environment at the time of the budget's creation inevitably change as time progresses. The solution? Dynamic budgeting, also referred to as ‘managing via forecasts’ versus budgets.

Dynamic budgeting is a more responsive and adaptable approach that helps businesses build resilience and thrive, and is particularly beneficial in periods of economic uncertainty. It creates a fluid system that adjusts as conditions evolve, rather than being stuck with a budget that quickly becomes outdated and irrelevant. Let's dive deeper into what this process entails:

Creating Your Forecast Scenarios for Dynamic Budgeting

Dynamic budgeting often uses three distinct, realistic forecast scenarios: worst, best, and likely. These scenarios must be based on solid, evidence-backed assumptions, avoiding arbitrary adjustments. For instance, in a manufacturing setup, the budget could start with a production forecast based on projected unit sales. This production budget can then inform your planning for manufacturing costs, including direct materials, labor, and overhead.

After mapping out your production expenses, selling and administrative expenses should be accounted for. When combined, these costs can provide a framework for a cash budget.

Enhancing Your Forecast Scenarios With Macroeconomic Drivers

While worst, best, and likely forecast scenarios are extremely helpful in budgeting, this approach can sometimes lead to contrived scenarios, concocted by whoever is defining them. These scenarios often involve blanket percentage changes in sales or performance, which don't necessarily reflect the complexities of the real world.

A more sophisticated approach integrates macroeconomic forecasting into the budgeting process. Organizations like ITR Economics provide overall industry forecasts for the coming year. For example, if the housing industry is projected to grow or shrink by a certain percentage, any business in home construction should start their forecast with this macro driver as a starting point.

Of course, each business is unique and may be more or less impacted by these macro trends based on a variety of factors, but using these industry forecasts as a foundation can lead to more realistic and grounded budget scenarios.

Flexibility is Key in a Dynamic Budget 

Within any fiscal year, it's crucial to expect and adapt to budget and forecast fluctuations. High-performing management teams develop action and contingency plans to navigate the impacts that deficit and surplus situations can have on capacity. 

Your year should start with a budget for the mid-range or likely forecast scenario, but the expectation should be that it will undergo continuous review. This constant reassessment allows for timely operational adjustments or other necessary changes. A key flaw of many companies is the creation of rigid operating processes that are hard to modify quickly when circumstances dictate.

Consider, for example, if your actual results mirrored your worst-case forecast. If sales volumes fall short, comprehensive fixed cost reductions will be required to decrease capacity. On the other hand, if your best-case scenario comes to fruition and sales volumes exceed expectations, then capacity must be increased to fulfill orders.

Dynamic Budgeting Plans for All Contingencies

Contingency planning often defaults to focusing on the worst-case scenarios. However, it is important to prepare for the potential challenges that come with best-case outcomes as well. Both scenarios carry capacity implications that need to be anticipated.

Action and contingency plans should include processes that outline how the organization will respond to changes in sales and operational metrics. Investing time in these plans enables you to address critical issues early, vet plan details, and ensure sustainability of key value drivers such as profitability and cash flow.

An effective sales forecast is a powerful tool that can guide management decisions throughout the year. It should be crafted with careful analysis of all relevant factors, and we strongly recommend utilizing the services of a professional CFO to help navigate this success.

Maintaining Your Dynamic Budget: The Importance of Regular Updates

You might ask, "How often should I update my dynamic budget?" There is no one-size-fits-all answer to this question because it largely depends on the nature and volatility of your business and industry, and is subject to external factors outside our control. However, as a rule of thumb, we recommend that you revise your budget whenever material changes in the environment occur.

A material change could be anything from a sudden shift in market conditions, a significant business decision such as a merger or acquisition, a new product launch, or a change in production costs. These changes often necessitate a revision of the forecast, which then drives an updated budget for the remainder of the year.

Some companies might find it beneficial to revise their dynamic budgets quarterly, aligning them with the regular rhythm of quarterly planning sessions for those who employ business operating rhythms via systems such as EOS or Scaling Up. Quarterly updates provide four opportunities a year to make course corrections based on the most recent information and adjustments to goals and priorities made during these planning sessions.

Dynamic Budgeting: A More Proactive Financial Planning Process

Dynamic budgeting is not just about flexibility in adjusting numbers but a shift in mindset towards a more adaptive and proactive financial planning process. By regularly updating your budget in response to market conditions, your business can navigate uncertainties, seize opportunities, and drive sustainable financial success.

Keep in mind that adopting dynamic budgeting can add significant complexity to the budgeting process. If your company doesn't already have one, it could benefit from a CFO's expertise. A Fractional CFO can be an affordable and effective solution to help you unlock the power of dynamic budgeting. Book a Complimentary Consultation Today.

Founded in 2001, FocusCFO is an industry leader in providing embedded fractional CFO services. FocusCFO works closely with small to medium sized businesses helping business owners gain control over three key financial and operational areas: increasing cash flow, reducing business risk, and creating a platform for scalable growth. This allows business owners to realize full financial control and increased value in their businesses.

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