A budget is one of the most important tools at a business’s disposal. Would you attempt a cross country car trip without a map and directions? Unless you’re up for an adventurous journey with no guarantee of reaching your destination I’m sure you’d take the time to plan your route.
A budget is your business map. Beginning where you are today, a budget charts the financial course you want to take during the coming year. You’ll forecast sales, calculate spending in important areas, decide how many people you will hire and when, and determine the amount and timing of capital expenditures (purchases of equipment, furniture, etc.). Your budget will show what needs to be done and when in order to achieve your financial goals.
A good budget is actually five budgets in one. The financial budget is a detailed income statement that shows revenue and expenses by line items. The lines items should correspond to your chart of accounts. The cash flow budget calculates the amount of cash excess or deficit by month. Remember, it is possible to show a net profit, but have a cash deficit! The advertising & marketing budget converts your marketing plan into dollars. The staffing budget shows your current staffing level and projects when new people will be hired. Labor usually is one of the top two largest expenses and should be budgeted with extra care. The capital expenditure budget maps out the purchases of fixed assets. These purchases are especially important to track because they do not appear on the income statement, and because they often require cash.
Hire A Professional
Mindful suggests hiring a professional to help on three fronts. First, a good budget requires the construction of a sophisticated spreadsheet. Not everyone has the advanced skills needed. Second, a professional is objective and will ask the hard questions about your vision that you may not be able to ask yourself. Third, a professional has a depth of knowledge you likely don’t. A professional has gained important insight into how business works because he has worked with many clients in different industries.
Gather the Right Tools
The two most helpful tools in building a budget are a business plan and historical data. A business plan spells out your strategy for achieving business goals and contains research supporting your approach. Don’t fret if you don’t have a business plan. Begin by writing down your ideas in an organized, bulleted format. Use these as your framework to build a budget. Fill in the details later and then adjust your budget accordingly. How your company has performed in the past is a good indication of how it might perform in the future. Use this as your starting point. Changes to strategy, cost structure, marketing and other areas will cause future results to diverge from the past. Adjust your budget to account for them.
Don’t worry if you’re a start up and don’t have historical data. Research other companies in your industry to determine their revenue and cost structure. Use this data to develop your own structure.
Revenue is the Starting Point
You must know your cash resources before you expend them, so we start by projecting revenue. Budget revenue with sufficient detail to act as a tool, but not so much detail to prove unuseful. As a rule of thumb, determine those products, services, product lines and service lines that, together, account for 75% of your total sales. Budget those in detail. Determine the quantity you expect to sell each month and their average sale price. You will be grateful for the detail when you are able to later compare actual results to the budget and determine the source of variance.
Cost of Goods Sold vs. Operating Expenses
Once you have revenue down, you’re ready to figure out how much to spend. There are two major categories of expenses and each is budgeted differently.
Cost of goods sold, or alternatively cost of services sold, are those expenses incurred in order to produce revenue. In the case of products, everything it takes to manufacture the product and make it ready for sale is a cost of goods sold. In the case of services, expenses required to produce the service is a cost of services sold. Usually, labor and labor related costs account for the bulk of the total. Costs of goods sold usually can be broken down on a unit produced basis and should be budgeted in this manner. Labor costs related to services are a little trickier because some of the cost may be fixed and not directly related to the number of units produced.
Gross margin is the result when cost of goods sold/cost of services sold is subtracted from sales. Gross margin is important because that is the amount leftover to pay overhead. A negative or low gross margin is a signal for you to review your production costs and to rethink your overall strategy.
Operating expenses are incurred to run the business on a day to day basis. Examples include: administrative employees, sales staff, occupancy expenses, marketing and professional fees. Some vary with sales volume, others do not. Some may be budgeted as a percentage of sales or other relevant number. Others are best budgeted in detail. Advertising and marketing expenses are an example of the latter.
Put It All Together
Combine your budgeted income and expenses and you have a financial goal for the year. Convert the income statement into a cash flow statement and you have advance warning of when outside funding sources might be needed. Add your staffing, advertising & promotion, and capital expenditure plans to the mix and your processes become automated.
This article just scratches the surface of budgeting. The process is complex, but well worth the effort.
