This is a judgment-free zone

If you’re already a master at financial planning, you’re welcome to skip this chapter. But, if you’re like the rest of us engineering types for whom this is all brand new, consider this a safe space to learn without judgment.

You’re about to enter a world of financial terminology that everyone else at the table seems to have learned somewhere, but was simply never mentioned in your Computer Science classes back in the university days. We’ll explain many of these terms in context as the budgeting process is laid out in the sections below.

Why create a budget in the first place?

A budget is a prediction of all the financial transactions that will take place for the company in the upcoming year. You perform this prediction exercise to give investors and operating executives the proper expectations for the health of the company during and after the upcoming year.

When executives have detailed budgets in hand, they can foresee corporate financial position months, quarters, and years in advance. That financial certainty empowers them to decide the more existential questions regarding the company’s future: when to sell, how to invest in growth, and measures required to mitigate potential risks.

With this same level of detail, you, and the other leaders of cost centers, such as product management, finance, and human capital, are given helpful guardrails for the management of your departments. The guardrails tell you what cash is available to you for spending on both headcount and programs in each month, quarter, or year, and also grant you full accountability for making decisions about which vendors to spend it on without needing constant oversight.

Similarly, the leaders of revenue-driving departments, such as sales and marketing, understand the overall revenue performance targets and can cascade these down into the individual performance goals set for each team member.

Once the budgeted time period has begun, leadership merely needs to compare actual company performance against the budget to identify departments that may need guidance or oversight – leaving those performing to plan to retain their relative autonomy.

When does budgeting begin?

It depends.

The more you increase the complexity of your company’s financials with product lines, regional offices, and sheer quantity of leaders involved, the longer it’s going to take and the earlier you’ll need to start. But, the one thing you can count on is that you’re all focused on getting the budget done before the start of your fiscal year.

Unlike we humans who abide by the calendar convention that begins the year on January 1, every company has the ability to select any starting date as the beginning of their fiscal year. From that date, the company then divides the 365 following days into four fiscal quarters and, in the event that the fiscal year does not begin on the first of a month, 12 further fiscal months. By designating a fiscal year, a company lets the tax authorities and investors know when financials will be reported quarterly and annually.

Why would any company choose to alter their fiscal year from the calendar year? It depends a lot on how the company operates. A classic example is a university. Many universities operate a fiscal year that begins in the summer, ensuring that tuition and funding for each academic class is accounted for within the same year it is received, without any crossover. Other companies simply choose to put their largest performing sales quarter at the end of their fiscal year in order to be able to show consistent quarterly growth on every annual report.

Ok, now that we know about the fiscal year, when does budgeting actually get started? Often, the budget cycle begins towards the end of the third quarter of the company’s fiscal year. If you haven’t been a part of the budgeting process before, it’s really important to make sure to raise your hand to the CFO somewhere in the third quarter so that it doesn’t get started without you.

What does a final budget look like?

The final budget looks like a profit and loss statement (also known as income statement or P&L).

In this statement, every row represents a category of income or spending that the company tracks and every column represents a month in the year. The first rows represent categories of revenue, costs of goods sold (COGS) categories are listed beneath, and operational expenses take up the largest number of rows at the end. Each cell holds the expected total spending for that particular category in that particular month.

Each category grouping is summed up to a total. This means you can see quickly what the overall revenue is expected to be for each month and the same for overall expenses.

Similarly, some standard calculations are performed based on these totals. These values, and percentage ratios calculated between one or more of the values, give financial experts the ability to quickly glance at a budget and understand the gist of what it means for the business.

One of the most common of these calculations is gross profit. Gross profit is always listed as the result of total costs of goods sold subtracted from total revenues. Another calculation is net income, which is sometimes reported as EBITDA (earnings before interest, taxes, depreciation, and amortization). Net income is listed as the result of operational expenses subtracted from gross profit.

These monthly totals also get summed up into quarterly and annual aggregates, giving the executives and investors the ability to predict the next year’s financial health quickly.

Once approved, the final budget is typically formatted so that the team can prepare a “Budget vs. Actuals” report throughout the year, comparing the real profit and loss statement to the model for evaluation.

What deliverables can you expect in a good budget preparation cycle?

In order to get to this final model profit and loss format, a great deal of work must go on first. While these deliverables may not have the same names at your company and may take on a greater or lesser degree of formality, the table below outlines all the deliverables that you should expect in a good budget preparation process.

Let’s review each, including what to expect from the deliverable and why it’s important:

Now that you know the steps involved, it’s important for us to note that a budget process rarely moves cleanly from one step to the next. Often, we get stuck on a specific decision, or a new piece of information gets discovered later in the cycle. When that happens, teams will need to revisit a previous step before they can move forward. It’s a good idea to plan for this sort of revisiting old territory, so you can be flexible as it happens.

Now that you’re familiar with the budgeting process, it’s important for you to keep your eyes open to some common traps that companies can fall into when they’re not used to the rigorous kind of AWS budgeting that you’ll be bringing with you this cycle. Below, are two key budget insights you’ll want to keep in mind each year.

Important impacts for the CTO

Sometimes just knowing the rules of a concept isn't enough. It's important to know the common ways this information can impact your specific role. We'd like to take a moment to call out two common budgetary impacts that every CTO should be aware of.

#1: Physical data center costs don’t appear in budgets

In strict accounting terms, asset purchase planning is not a feature of the expense budget process. While those words may not mean much to you, as a CTO you should know that any planned migration of workloads from data centers to AWS is going to be adding expenses into your budget, not just moving those expenses from one category to another.

Why is that? Interestingly, any major purchase made by a company is not considered an expense. Rather, major purchases are considered to have some sort of lasting resale value to the company after purchase, and as such, it’s recorded as an asset and not an expense.

This subject can be confusing so let’s use some examples with normal business purchases. Let’s say that you need a new mouse for your computer. It’s a relatively cheap purchase and, in the event that you left the company, the company would spend too much effort in employee time seeking to resell the mouse than they spent to purchase it in the first place. As a result, we categorize the mouse purchase as an expense. You probably even fill out an expense report for that purchase so it can be recorded as such.

Now, let’s say you need a new laptop. This is a more expensive purchase and, in the event that you left the company, the company could easily reformat and resell the laptop to recoup some cash (at least for a few years after purchase while it still has resale value). As a result, that purchase gets categorized as an asset. In fact, it’s probably purchased on your behalf by a central purchasing department, and not through the typical expense process.

While your company does spend cash to pay for asset purchases and expense purchases, the ownership of the asset conveys value to the company, while the expense does not. As a result, assets are reported as equal to their current cash value in the company’s financial statements and do not appear in the annual budget.

But before you think companies just go out and purchase high-value assets without planning, think again. Asset purchases are actually planned independently of the budget cycle, often forecasted and prepared many years in advance.

It should now come as no surprise to you that AWS resources have no lasting value to a company and are therefore always planned as expenses in the budget. Similarly, spending on servers, racks, and switches is always recorded as an asset.

In developing a budget that features an expanded reliance on AWS vs. data centers, you and your finance team need to be prepared for your corporate budget to become much heavier on expenses than before, knowing that, in turn, the cash demands for planned asset purchases will decrease meaningfully.

If you haven’t prepared your CFO for this yet, the time to start that conversation is right now.

#2: Question carry-forward strategies where budget problems lurk

It can be safe to assume that you’ve picked up this AWS budget guide because there have been concerns about the proper budgeting of AWS historically at your company. Perhaps some spending was under-projected, or perhaps the ratio between your COGS and operational spending didn’t match your actuals?

Well, if you approach your AWS budget like accountants typically approach a cost-side budget draft you could be bringing your problems with you. Under typical budget planning procedures, each department will likely work with the financial team to highlight planned changes to the previous year’s spending in order for the accountants to aggregate this with the previous year’s spending in creating the next year’s cost-side budget.

In order to truly resolve your AWS budget concerns, it’s important for you to learn the concepts of Top-Down and Bottom-Up budgeting. The carry-forward approach described above is a representation of Top-Down budgeting, which is most common whenever a budget process is perceived to be normal and without major operational or strategic change. With Top-Down budgeting, we assume that not much will change from the previous year and that all intended changes are known when the budget cycle begins.

On the contrary, Bottom-Up budgeting assumes that nothing will be the same as the previous year. Instead, all projected sources of spending are enumerated for the upcoming year and individually added together to come up with a total sum.

It’s our recommendation that any company with AWS budget issues should reconstruct the AWS budget at least once using the Bottom-Up budget methodology. With this approach, technology and finance teams can uncover hidden allocation assumptions and can build a shared understanding of exactly all sources of AWS spending. From this shared understanding, new strategies can be developed collaboratively using both financial and technical expertise.

Read on to Chapter 3: Building a world-class AWS operating budget using historical spend analysis where we outline exactly how to apply the Bottom-Up budget methodology to building budgets for existing and new AWS projects.