March 12, 2010

This positive attitude is often reflected when we budget.  We'll project our revenue under the assumption that our business will do well in the coming year - and plan our spending for the coming year accordingly.

More than once, however, I've found myself bitten by this kind of optimism.  I'll be spending within my budget, which I already carefully considered in the past, but then I'll find that revenues aren't quite matching the sunny expectations I put down on paper.  Suddenly, I find myself in a money crunch, even after planning ahead carefully and assembling a budget.

My solution to this problem is what I call "the three budgets."  It's worked for me for several years in terms of planning ahead realistically for my expenses.

Here's how it works.

First, I assemble the coming year's budget using nice, sunny revenue forecasts.  This is the type of budget I would have assembled normally in the past, so it's actually an enjoyable activity.  I also plan spending in accordance with that sunny revenue forecast.

Next, I assemble a second budget using "worst case" revenue forecasts.  The hard work for this part is determining what exactly "worst case" is.  I usually try to determine what I would consider to be a very, very poor year for my business, then cut a little bit more from that forecast.  Using this revenue baseline, I then assemble a spending budget that matches the revenue.  This is also a challenge, because I often have to think about where I would cut my spending to make ends meet.

Finally, I average the two revenue predictions and assemble a third budget.  Once I make the hard decisions about what to spend in each category (using my optimistic and my pessimistic budget as guides), I then assemble this final budget.

I use that third budget as my main budget at the start of the year.  For the first quarter, I plan my spending according to the "average" budget and watch where my revenue falls.  If I find that I'm bringing in more than I'm budgeting for, I might move to the sunny budget for the second quarter, knowing that I have some cash reserve built up.  If I find that the "average" budget is exceeding true revenues, I'll go to my slim budget for the second quarter.

The advantage of this method is that it forces me to think about these questions outside of the heat of the moment.  If I were to just stick with the sunny budget and have a revenue shortfall, I would be prone to poor decisions because of the emotion of the moment.  However, if I already have a well-considered plan in place for just that event, I would be able to just move to the more conservative budget and not open myself up to irrational decision making.

Three budgets work for me.