Bottom's up budgeting for heads of engineering
It’s that time of the year again, the time for making projections for a new fiscal year and with that comes one of my favorite annual exercises: planning & budgeting. I’ll be covering the budgeting process, focusing on my role as a head of engineering. The process that I will describe will cover doing the same exercise twice: tops down and bottoms up. I’ll cover the bottoms-up approach in this post and the next one I will cover the top-down approach too.
But first, why both with budgets to begin with? Startups are small and nimble and don’t need corporate bureaucracy slowing them down, right? Well, no.
Budgeting is a crucial exercise and a fundamental financial management tool. Budgeting serves as a crucial mechanism for maintaining fiscal control and achieving strategic objectives. It allows individuals and organizations to meticulously track their income and expenditures, ensuring that financial resources are utilized in alignment with established priorities and goals.
This process of budgeting is not merely a transactional activity; it is a strategic approach that transforms aspirations into achievable targets. Through budgeting, individuals and organizations can make informed decisions, efficiently allocate resources, and set realistic financial targets. It transcends the basic functionality of financial tracking, acting as a catalyst for realizing both short-term and long-term aspirations.
Proper budgeting (and monitoring of actual spend) assumes a pivotal role in safeguarding the financial health and prosperity of an organization. It enables businesses to monitor their financial performance by juxtaposing actual results against pre-set budgetary benchmarks. This comparison is integral to managing cash flow effectively, ensuring sufficient liquidity for operational needs and future investments. The disciplined practice of budgeting lays a foundation for sustained financial stability and growth, ensuring that organizations can navigate economic challenges and capitalize on opportunities.
In short, budgeting is absolutely important and especially so for companies that require additional capital to fund their operations: startups!
Lastly, a budget cannot be done in void. It needs a strategy to anchor it. The strategic direction of the company defines where and why the company is headed in a certain direction. This strategy is the foundation on which budget are built on. All investments made must be supportive of your company strategy. Therefore, as a head of engineering you use this to project how many resources you need to support the overall company and product strategy.
Bottom’s up budgeting
Bottoms-up budgeting is a granular approach where budgeting starts at the departmental level before being aggregated at the company level. It involves detailed analysis of individual expenses and requires input from all team members. This method contrasts with top-down budgeting, where the budget is set at the top level and trickled down to departments. I’ll cover the more critical elements of budgeting for heads of engineering.
Budgeting for headcount
Once you know where you are headed - your strategy - you can start projecting resources needed to get there. It should come as no surprise that the largest line-item on the engineering budget is headcount. I break that exercise into two parts: how many and how much.
How many?
Projecting the number of future hires you require is a collaborative exercise. You must have a very good understanding of the major product initiatives that are needed to support the business in the next fiscal year. Are you launching new products? Are there must-have new capabilities that you must build next year? These, and similar questions, help you answer the “how many do I need”.
When projecting the number of hires required over a fiscal year I also try to project those by level or experience. Will I need all my hires to be highly experienced developers, or can I have a mix of juniors and experienced engineers? There are many good reasons to having a balanced team, experience being one of these balancing points, but for the sake of budgeting experience tends to be highly correlated with cost. Hence, it’s important to project how many of each profile you will need. It’s also important - for cash flow purposes and balancing recruiting capacity - to project your hiring needs over the entire year.
How much?
You’ve projected the number of hires you need over the next fiscal year. Next comes projecting the cost of making these hires. Broadly speaking there are two large cost categories: salaries and equity.
For salaries, you should be assessing the current market rates for different engineering roles. Factor in experience, skill set, and regional cost of living. Use tools like Glassdoor or Payscale for guidance. Also, consider potential salary increments for your existing team. Your HR team should be able to provide you with this data.
Next comes equity which is a common component of startups’ compensation packages. Determine how much equity to allocate to new hires and existing team members as well. The number of shares you are able to offer per role is usually set by your finance department. The amount of shares offered will differ by organization, role, startup stage, valuation and many other factors like the employee option pool.
The end result of projecting both how many hires you need over time and how much they will cost is illustrated below.
Observe how the above makes projections of hires, of different profiles, over time. In the example above S=junior engineer, M=mid-level and L=highly experienced. I also project costs per each profile.
Next comes the “how much” part, which is illustrated below. These figures are derived from the number of hires (per profile) projected in the diagram above along with assumptions on salary and equity costs per profile. The assumptions I laid out in my sample sheet are illustrative.
The illustrative Google sheet I used is here
Operating expenses: Cloud costs and more
Operating expenses in engineering predominantly include cloud services, software subscriptions, and maintenance costs. If you aren’t running infrastructure in the cloud, you will need to project capital expenditures to purchase new equipment (servers, switches, storage and so on). The exercise is similar to projecting cloud costs, but comes with an extra bit of accounting headache: asset capitalization and depreciation.
Cloud (or infrastructure) costs
If you business is in the cloud, meaning you are a SaaS vendor that runs their infrastructure in the cloud, you must, must, absolutely must pay a whole lot of attention to your cloud costs. Your cloud costs are considered costs of goods sold (COGS) and thus impact the company gross margins. Gross margins are a key metric that investors pay much attention to. A company with high gross margins is able to command a premium to its products versus one that isn’t. Controlling your cloud costs helps you derive higher margins. The key to being able to project your cloud costs well are unit economics.
Unit economics refers to the direct revenues and costs associated with a particular business model, expressed on a per unit basis. In this context, "unit" can mean a single item, customer, or transaction, depending on the business and industry. The concept is crucial for understanding the fundamental financial viability of a business. The basic formula for unit economics is:
Unit Profit = Revenue per Unit − Cost per Unit
Yep, rocket science. I know.
The revenue side of this equation will be dealt with my your finance and sales teams. A good chunk of the cost side will be covered by you. There are other costs beyond cloud that must be included in the cost per unit.
Therefore when projecting cloud costs you are trying to project the costs associated with realizing the business goals for the year. These should be expressed in unit economic terms e.g. number of new customers, total revenue (which can be translated to number of new customers). You then need to project the cloud resources needed to support this book of business. This entails having a very good grasp of the resources typically consumed by a customer, or transaction, or whatever your “unit” is.
There will often times be exceptional situations where you need to expand your cloud footprint in anticipation of future growth. For example, you might want to run your SaaS infrastructure both in the US and overseas in Europe for GDPR. You need to project this spend too, it’s material.
Miscellaneous items
Do not overlook costs such as team travel, continuous education, and team building activities. Estimate travel costs for conferences, client meetings, or remote team gatherings. Consider both domestic and international travel if applicable. Also, do allocate funds for training, workshops, and team-building activities. These are vital for skill development and maintaining a positive team culture. Also include any software costs. These include incremental Jira seats, CoPilot licenses and so on. Finally, if you are investing in building a patent portfolio, then do allocate some budget for that as well.
