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Developing a Business Budget
Regardless of size, it is important for any business to understand how much money it makes and how much money it spends in any given period. Business insolvency surveys show that running out of cash is one of the major reasons businesses fail. At the other end of the scale, it is also important to be able to understand how much profit is available within a business to commit to the essentials for growth such as higher rents on larger premises and additional resources.
Whether you are faced with developing a business budget for the first time, providing input for your particular division to the company’s overall budget or undergoing the usual annual process that you have completed many times before there are a number of key points to keep in mind.
- Why are you developing this budget?
- What needs to be included in the budget?
- How are you going to put together the budget?
There are a number of good reasons businesses put in the time and effort to develop and document a budget.
- Goals: The budget should reflect the strategic and operational goals that the business has set itself for the period. For example, increasing sales by 5% by expanding into a new territory or releasing a new product or service or increasing administration efficiency through the implementation of new software tools, processes or procedures. Whatever the reason, these goals should be listed and the assumptions behind how they are going to be achieved clearly documented so that they can be easily articulated and defended. In reality, a budget is simply your business plan in numbers.
- Financier Needs: Bankers and other financiers will expect the preparation and presentation of a budget by management when businesses are asking for a loan or other form of funding, such as equipment finance. Their primary concern is the ability of the business to trade and afford the agreed repayment schedule. Financiers will also expect regular updates throughout the budget period on how the business is tracking versus the forecast and explanations on any variances to satisfy them that they are not at risk of payments not being able to be met on time. So the budget needs to be realistic and not just designed to make the case look good for granting of the loan request.
- Staff Incentives: Key staff, including divisional managers and supervisors overseeing costs and expenses in their own areas, need to be accountable for their performance in line with an overall business budget. This means that not only should their incentives and any bonus payments be aligned to a budget, but they should also have input into the development of the budget and believe that the targets they are being set are realistic and achievable. Remember, motivated staff are much more likely to achieve their targets.
- Decrease Risk: Budgets are essential in business decision making, for example, when is the right time to invest in that new processing machinery or take on that extra sales person? Without a budget these decisions can significantly increase business risk if they result in a cash flow short-fall as the revenue associated with any investment decision usually lags the need to fund that investment.
So, having justified the need for a budget, or not having the choice, what needs to be included in the budget to make it meaningful and useful for tracking performance throughout the budget period.
- Revenue: The more detail that can be included in revenue lines that can be reported against throughout the budgeted period, the better information you will have for next year’s budget and the easier it’ll be for management to see which areas of the business are over-performing, going to plan or behind their forecast sales. For example, if the business has clear sales territories the revenue expectations for each territory can form a line in the revenue budget, similarly if the business has a number of key sales items (or classes of goods) these can have their own sales forecasts, also sales to existing customers and sales to new customers can help quickly evaluate whether sales growth strategies to reach new customers are succeeding.
- Direct Costs: Direct costs, or costs of goods sold (COGs), are those costs which are incurred that are directly related to the production of the product or service the business provides on a day-to-day basis. These are usually raw materials and wages for staff involved in the manufacture or actual delivery of the service directly to the customer. These will often decrease or increase with sales volumes, especially if your business has employees that are on casual contracts. Subtracting the direct costs from the revenue will give you your business’s gross margin.
- Expenses: This is where all the other costs, expenses and overheads are recorded. The items that are needed by the business to operate but do not have a direct input to the production of your product or service, they are one step removed from the factory floor. Include all wages for back office and support staff, IT and software support, telephones, rent, printing and stationary, travel, insurance, pest control, electricity and other utilities, accounting fees, business registration costs, motor vehicles and fuel etc. Many of these items will have fixed monthly costs, like rent, but others may vary or only be payable quarterly, such as electricity bills. In your budget you should include a monthly cost for these quarterly bills, so that you spread the cost of producing the businesses revenue into the monthly periods where it is actually used and not just paid for. This may involve estimating monthly amounts from other periods, in which case it is better to be conservative and take the highest quarterly bill as your average rather than the lowest. Taking the expenses from your gross margin will give you your business’s expected monthly operating profit.
Rather than sitting in a room with a blank piece of paper to start your budget, take advantage of the information that is available around you as much as possible.
- Last Budget: If you went through this exercise 12 months ago, pull out the budget from last year and look at the different revenue areas and cost/expense lines that were deemed necessary then. Has anything changed? Are there any new sales or cost lines that didn’t exist last year that need to be included in this budget? This can be your template for your budget. If you are starting from scratch use the web to look for budgeting templates, or talk to your accountant or a specialist advisor to help you set up your budget template.
- Actual Data: In addition to last year’s budget, if available, take a good look at the actual revenue results that were achieved last year and the level of costs and expenses that were incurred in producing that revenue. What has changed this year? Will increasing your revenue forecasts result in a proportional increase in costs, or are some costs likely to remain fixed (such as your rent – though don’t forget about those standard annual increases that every landlord writes into rental agreements).
- Divisional Estimates: Getting estimates from divisional managers and supervisors about their individual sales forecasts, resource requirements and associated costs is also extremely valuable, especially when you are going to be using the budget to hold them accountable for performance during the forecast period. Armed with a number of divisional estimates, you can then consolidate all the revenue, cost and expense lines into one overall budget document and then determine the additional business costs that need to be overlaid onto these forecasts.
My Business Budget Following these steps will give you what’s known as a ‘Profit and Loss’ budget. Month by month summaries of expected revenues, costs, expenses and resulting business profitability. But be careful, as this does not necessarily correlate to the movement of cash in and out of the business on a monthly basis, it is the theoretical performance of the business for the budget period.
If you have plenty of working capital (cash in the bank or access to funds such as an overdraft facility) you may feel comfortable enough not to also produce a corresponding cash flow budget. However, if you know that your business is likely to experience periods of lower revenue due to known seasonality of trade, or that profit margins are relatively low and cash flow may be an issue, then please read our follow on paper Producing a Cash Flow Budget for a few hints and tips about the things you need to consider.
If your business is experiencing periods of lower revenue or you require any further information about any of the solutions outlined above please contact us and we will be happy to help connect you with an appropriate provider in your area or discuss in more detail short and long term solutions that may be available to your business.
Article written by Sheree Cross and Bernard Stapleton