We interrupt our regularly scheduled programming to talk about… budgeting.
It’s budget season as we head into the fourth quarter of the year, a process which has been equal parts mystifying and demoralizing for me in the past. But there’s hope! With a little bit of financial intelligence under our belts, we science-folk can start to make sense of how this process works.
Let’s take a step back and write out a functional definition of budgeting: What you can afford in the current market conditions given the strategic direction of the business. (credit to my friend Bill King for this one)
Let’s pull that definition apart.
What you can afford depends on your revenue projections and financing— we’ll talk about that a bit more below.
The current market conditions take into account things like interest rate and overall economic climate (we’ll talk a lot about how these factors impact how companies think about internal and external investments later in our series where we discuss ways of evaluating return on investment and something called Net Present Value).
And the strategic direction of the business includes factors like: is this a start-up? Are you positioning your company for sale or scale? Is this business a nice cash cow, but you don’t care much about growth? These factors speak to the phase a company is at as well as the mindset of the leadership/owners. As you will see below, this perspective becomes central to how incremental budget dollars are allocated.
Where to start? Well, before you can set a budget, you need to be able to approximate what growth trajectory your business is on.
Step 1: Revenue projections
So step 1 is to answer the question: what are your revenue projections for the coming year?
For the purposes of illustration, let’s imagine it’s 2021 and we are working on the 2022 budget for our exemplar company, BioTechne.
Of course, knowing what happened in 2022 is quite handy here, so we can project with absolute confidence something like 20% top line growth in 2022. While it’s good to know the future for the sake of our example, of course normally you’d be forecasting based on past trends and current information about the market and business you are in.
Step 2: Gross margin percentage
Step 2 is to calculate the gross margin percent. In this case, it is a pretty consistent ~68%. Now if you knew you had a major product improvement aimed at improving margin in the coming year, you probably want to take that into account, but here the past was a pretty good predictor of the future, so using the 2021 gross margin percent was pretty spot on for what happened in 2022.
Step 3: Calculate incremental budget
Step 3 is to calculate your total incremental budget. This formula is the Revenue Projection for the coming year minus the revenue for this year, times the gross margin percentage. Here we have the benefit of omniscience, so we can calculate (1,105,599-931,032)*68% = 118,706 as our incremental budget.
Step 4: Allocation
Step 4 is allocation, which really comes down to what management wants to accomplish in the coming year.
- Let’s say you just finished development of a new product and now you want to really hammer on selling it. In that case, you might allocate most of that incremental budget to sales in the coming year to accomplish that goal.
- Perhaps you have an ambitious product development agenda for the coming years. Here you might allocate more incremental budget to your R&D team (yay say all the scientists!).
- Or maybe you know that your product volume is increasing, for instance, in your clinical testing lab. In this case, investments may be needed either on the operations front to directly support that increase (headcount, equipment, etc) or on the R&D front to create workflows that will scale to support the increased testing volume.
- Lastly, you may have objectives around returning money to shareholders, reaching profitability, or stockpiling money for an impending recession. In these cases, you may choose to not incrementally increase any department’s budget beyond what is absolutely necessary, in order to create shareholder value (higher investor confidence, leads to higher valuations and access to capital).
Of course, all of this illustration was done in the happy scenario of a growing company. If your company is on a downward trajectory, then the math gets inverted. Whose budget is being cut and by how much? Unfortunately, this scenario is all too common this year.
Making sense of ‘mismatched’ budgets
And there is a good perspective to be gleaned for scientific leaders in our current economic reality. We all love to see our teams grow; in good times and bad, most of us feel like we don’t have quite enough resources to accomplish everything we want. However, every new headcount we ask for should be carefully considered. In hiring, we are making a commitment to another person, to their career, and their future. We have a responsibility to these potential new hires and our existing teams to not get too far out over our proverbial skis— the budget has to bear the new headcount this year and in years to come. We need to take a longer view than the resource constraint we see in front of us, and ask ‘can we make this long term commitment at this point?’ and ‘how else might we meet the resource need in front of us?’
At a very high level, that’s the gist of budgeting: figure out what you can afford in the current market conditions given the strategic direction of the business, and allocate it on things that advance your key objectives for the year. So next time your department does not get the budget you were expecting, use it as an opportunity for understanding an alignment: ask how the allocation makes sense given how the company is doing financially and what the company is trying to accomplish in the coming year. Getting clarity on those two things will almost certainly help you be more effective in leading a scientific function.
In the next post, we’ll get back to our regularly scheduled programming and discuss key financial ratios and why they are important.