What is a budget?
There are several uses for a budget. It can be used as an internal planning tool, a management tool, and as an external projection of operations as part of a plan to secure financing. A budget is a plan or a financial roadmap that provides the financial support for your business strategy. It is used as a tool to allocate the scarce resources of your company in the form of cash, people, and equipment. It can be used as a decision-making tool that can provide direction in how and when to spend your money. It is also a tool to use to measure the success of your business and to highlight areas that may require your attention. When a request for financing is submitted to a lender or an investor, a budget is a necessary part of that plan.
Budgeting Process/System
When should your budget be developed?
A budget should be developed prior to the beginning of your business year as part of your planning process and needs to be aligned with your business strategy. It should be complete before the beginning of the year it is written for. It can be very useful to develop a rolling budget cycle to always be looking twelve months into the future.
Who should be involved in the budgeting process?
Your budget is most effective when the people who impact the outcome of the business and have authority to spend money and make decisions are involved in developing the budget. The people with day to day involvement in the operations of the business have a good understanding of anticipated needs. Final approval is by owner or general manager/CEO or CFO after all revenue and expense items are complete. The final budget should be distributed to everyone who has authority to commit funds.
Budget Development
A complete budget includes and Income/Expense Budget, a Capital Expenditures Budget, and a Cash Flow Budget. It is important that all areas of the budget are addressed in order to have a reasonably accurate projection of activity.
- An Income/Expense Budget includes revenue or sales estimates, all direct expenses (variable costs related to the production of revenue), and all operating expenses, resulting in an estimated Income Statement. Separating the budget by product or service line, region, or other important segments can facilitate analysis of your financial results.
- A Capital Expenditures Budget is a plan to establish infrastructure to meet expected demands of the business. This would include major purchases of assets needed to support your business.
- The Cash Flow Budget combines the income statement and capital expenditures plan into a plan that will determine ability to meet obligations as they come due. This is a critical element in planning and budgeting and should be done by month rather than quarter or year in total as the timing of revenue and spending is at least as important as estimating revenue and expenses.
In developing a budget, you will need to establish estimates for most line items. In developing your estimates, always define and document your assumptions. What are you assuming with happen for these numbers to become real?
You will need to use multiple sources to estimate revenue. Start by looking at your history and analyzing trends that have occurred over time. You will need to consider the general health of the economy to determine if your assumptions are realistic. Also consider customer commitments and pipeline numbers. If you have customers with repeat business you can include that in an estimate. Also consider the sales conversations that are in process to estimate the revenue you might receive if you are able to close those opportunities. Look at market research to estimate the potential market. Also consider the option of price increases. Customers are never excited to hear this, but reasonable increases should become a standard business practice.
There are two types of expense you need to estimate, direct, or variable expenses, and operating or “fixed” expenses. Direct expenses are related to the revenue you generate and should be easy to estimate once you have established your revenue targets. Use established relationships between your revenue and the cost of service or product that provides your revenue to estimate these costs.
Operating costs are those that you incur to keep the doors open and include rent, administrative costs, interest, and marketing. Focus on the primary expense categories to be the most accurate with the largest segments of your cost structure. To estimate these costs, you can look at history, contractual commitments (rent of example), market research, quotes from suppliers and other estimates. Be sure to consider potential price increases from your vendors and if there are anticipated increases in payroll. If your business is growing, be sure to consider the need for additional staff in the budget process.
The income and expense budget is likely to go through several iterations before it is complete. Put all your numbers together to determine if you can achieve the desired results with the assumptions you have made. It is very likely that you will need to go through the budget and adjust it to determine what you can do and still achieve a profit. This is the first step in using your budget as a management tool – set your priorities and make your decisions on that basis.
A Capital Expenditures Budget addresses upgrades to plant, equipment, and facilities that your business will require. Office equipment such as computers and printers, significant software investments, and furniture are included in this plan. The capital expenditures budget should be based on research into specific pricing and quotes whenever possible. The budget should include the source of funding to acquire the assets. Will the purchase be funded by the cash flow of the business? Through owner’s capital contributions? Loans or leases? In the budget include when the asset will be acquired, what financing is necessary, and how it will be repaid.
The Cash Flow Budget combines the Income and Expense Budget with the Capital Expenditures Budget and is absolutely critical in running a successful business. Even a business that has a profit for the year, and positive cash flow for the year, needs to pay careful attention to the timing of cash flow to avoid having a cash shortage during the year and jeopardizing the health of the business.
Start your cash flow budget by itemizing all of the items on your Income and Expense budget as cash and non-cash items. A very common non-cash expense is depreciation.
Timing of all inflows and outflows is at the core of the cash flow budget. When do you receive the cash in the door for the products or service that provides revenue? Do you sell for cash or on credit? How long does it take for you to collect your credit sales? Consider payment of expenses that do not occur at a steady pace throughout the year. For example, do you pay your property and liability insurance all at one time? Be sure to place this on your cash flow budget in the month you actually make the payment. Many of your expenses recur each month at about the same level – enter those items as equal monthly installments.
Not all of your cash payments are going to be part of your Income & Expense Budget. Payments of principal on outstanding debt are a firm example of that. Be sure to include both interest expense – that is included on your Income & Expense Budget – and principal payments. These are reflected by changes in your balance sheet.
Any cash you use to acquire the items on your Capital Expenditures Budget also need to be included in the Cash Flow budget. Quarterly income tax payments are another item you need to plan for on your Cash Flow Budget.
Budget Management
Developing your budgets is just the first step in the process. After you have completed the process and your budgets project a successful year ahead, you can begin to use them to manage your business.
One critical way to use your budget is to make decisions about managing your business. If an expense comes up that was not anticipated, you may need to decide not to incur the cost, or you may decide you have to forgo another cost on your budget in order to add this cost. Your budget supports the strategy of your business and reflects the priorities you have set to achieve success. It is most effective when used as a guide to stay on track to meet your goals.
Comparing actual results to your budgeted results throughout the year
is another way to use your budget. A monthly comparison by line item is
the most useful. Your actual results should be recorded to the same
accounts that you use to set your budget so that a comparison is easy to
do. Calculate a variance in dollars and as a percent of the difference
between actual results and your budget. Analyze the differences. What
actions do you need to take to get back on budget? Why is there a
difference? You can make business decisions with this information that
will result in a more successful year for your business.
Your budget is only useful as a business tool if you use it to manage your business throughout the year.
Summary
The process of building a budget can help you understand how your business operates and the interrelationships of the financial aspects of your business. Your budget will help define how resources are allocated to specific parts of your business to achieve success. This is a balancing act to be sure that you can operate profitably and with positive cash flow for the best possible outcome. Using your budget as a tool throughout the year is the true value in building it. It can influence and guide your decision-making and activities on a day to day basis as you work toward business success.
