Budgeting is detailed planning for the allocation of funds in a business. It is sometimes referred to as the financial picture of the business; i.e, how the business plans to spend its financial resources.
Whether your business plan is for next year, for the next three years, or for the next five years, budgeting can help you keep on the right road. Once you've developed your business plan, preparing the first budget is easy -- think of your budget as the financial picture of your future.
Because operating a small business is not a cut-and-dried affair, the first budget you prepare often uncovers problems with your business plan and helps you determine whether or not your financial goals are within reach. The budget will also help you focus and select from alternatives to help make your business plan realistic and achievable.
Your budget gives you answers to questions such as: What sales will be needed to achieve the desired profit? What will the equipment that is needed cost? Can you afford the marketing and advertising that you outlined in your plan?
When you complete your budget you will have one of the most effective management tools of all -- a benchmark that you can use each and every month to check your progress towards your business goals.
Essentially, a budget is a translation of your business plan into numbers. In its simplest form a budget is a detailed plan of future receipts and expenditures - a projected income statement. Right from the beginning you can use your budget to validate the activities you have planned for the coming year. Will you be able to afford additional staff? Do you need to expand your facilities or equipment? When will be the best time to start your new sales campaign? Do you have a period where sales are slow and making ends meet is a challenge? Knowing what all your business activities will cost and when such expenses will occur will help prevent any unexpected surprises that could lead to financial problems down the road.
Once the period for which you have budgeted is completed, you can compare actual results with anticipated goals. Get into the habit of making this a regular part of your business routine. You may find it takes discipline at first, but the rewards are high. You don't have to do anything elaborate - just compare your budgeted figures to your actual results. Then, ask yourself why the numbers are different. If some of your expenses, for instance, are higher than you expected, do you need to look for ways to cut them or has business increased? If your sales aren't on track, what has happened to cause the difference? Use the information constructively so that you can make adjustments immediately, if needed, and improve your next budget.
Your budget can also be used to assess whether your present profit adequate. In a small business, the year end profit should be large enough to make a return on your investment and return on your own work, i.e., pay you a salary.
Value of Owner's Service
This is the net profit made in the business after taxes. Hopefully, it is a positive number, although for some start-up businesses that may take a year or two to achieve. Some people compare this number to the amount you could have earned if you worked at your trade for a pay check. That, of course, does not take into consideration the intrinsic rewards of working for yourself.
Return on Investment (ROI)
The year end profit is too low if it does not also include a return on the owner's investment. That investment includes the money you put into the firm when you started it and the profit of prior years that you left in the firm. You calculate Return on Investment by dividing the fiscal year's income by the amount of investment in the company. Investment also includes any long term debt you have taken on to support running the business.
Your Targeted Income
After you know what you made last year, you can set a profit goal for next year. Be sure that your goal includes payment for your services and a return on your investment as noted above.
You may need to make some changes to your recordkeeping system to ensure that you are collecting enough information in the right format to assist with your budget. Or, it may be that you need to produce a profit and loss (or income) statement at more frequent intervals to keep track of the seasonal fluctuations of your revenues and expenses. A good place to start is with your Chart of Accounts. Consider each expense category listed and estimate the amount that you will spend for this category in the next year. Last year's income statement is a good reference point, but don't rely entirely on it -- consider changes in your markets, price changes, and cost increases, always going back to your business plan to make sure you are addressing all the goals and activities you want to accomplish.
The next step in preparing a budget is to determine whether you can achieve your profit goals. To do this, you must project your fixed costs and your variable costs. From these three figures -- targeted profit, fixed expenses, and variable expenses -- you can determine how much income you need to make to meet those goals.
As the name implies, fixed expenses generally stay the same over time. Some fixed expenses are rent, telephone, taxes on property, depreciation of equipment, interest on borrowed money, building maintenance costs, and office expenses.
Variable expenses usually change in relation to sales. In a business that produces a product, the cost of materials or goods for resale are the largest variable expenses. In some service businesses, the cost of labor is the biggest factor. Sales commissions, direct wages, payroll taxes, insurance, advertising, and delivery expense are other examples of variable expenses.
Once you have reasonable estimates of your expenses, you need to determine and evaluate your required revenues from sales. Calculate revenue from the ROI and expense estimates. Then take a realistic look at the revenues you will have to generate in order to make your targeted profits. If you're a service business, what is the hourly rate you will have to charge and is it realistic? Will you need to increase your customer base? If so, is this increase achievable? If you manufacture and sell a product, are you able to make and sell that many units with your current equipment? If these revenue projections aren't realistic, you will need to revisit your ROI and expense projections and adjust them.
After your budget is set, it becomes a marvelous tool to keep on top of what is happening in your business. Break your budget down into monthly amounts. This allows you to check for any discrepancies that may not show up readily in the annual figures. When many items are added together, it is easy for an error to creep into the totals or for you to overlook items.
During the year, the monthly budget provides you with an important financial management tools. By looking ahead at the coming months' budget you can anticipate peak periods and schedule stock and labor to handle sales volume. You can also plan vacations, special promotions, and inventory-taking for the slow periods.
A comparison of your monthly profit and loss statement to your budget indicates whether or not you are achieving your business plan goals. Set up a simple worksheet to compare actual expenses to your budget and get in the practice of reviewing a) where all the money goes, and b) any differences from the amounts you budgeted. Thus, you can pinpoint and work on the problems that have occurred during the month.
Here is sample copy of a budget to show how one is set up. The example is for an annual budget. Once you have the annual budget, projecting it monthly makes it even a more useful tool for monitoring throughout the year. Many financial software packages will provide you with templates to fill in for your budgets and reports to keep you on top of how you are doing at meeting your projections.
Summary of the Budget Process
- Review last year's budget to see how well the business performed. Make a list of what changes may be needed in operations or the budgeting process based on differences between actual and projected amounts in each category.
- Calculate your return on investment (ROI) for the previous year. Determine a realistic ROI goal for the coming year.
- Estimate changes in expenses for the coming year.
- Calculate the revenues needed to meet the ROI goals and anticipated expenses.
- Evaluate how realistic the revenue goals are.
- Readjust expense and ROI projections so that revenue goals are achievable.
- Monitor budget income and expense categories monthly, comparing actual to budgeted figures so that you can address any major aberrations immediately.
If this is your first year of budgeting, you obviously will not be able to do steps 1-3 above. You will start with projecting an ROI goal and expenses, then continue with step 5.