Budgeting in a Small Business

Many owner-managers run their businesses without a planned goal. In trying to survive from week to week and from month to month, such owner-managers overlook an important management tool -- budgeting. Would you ever consider going on a journey without determining what supplies you might need, the mode of transportation or how to take care of things at home while you're away? Of course you wouldn't. Why then would you set off on one of your most important adventures, starting or managing your business, without a clear picture of what's ahead and what resources you'll need to get there?

Whether the plan is for next year, for the next three years, or for the next five years, budgeting can help just as a map helps you keep on the right road. Think of your budget as the "financial picture" of your future.

Because small business is not a cut-and-dried affair, the first budget you prepare often uncovers problems with your 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 so that your plan is realistic and achievable. When the figures are all together, you have 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?
And many more.

When you complete your budget you will have one of the most effective management tools of all -- something that you can use each and every month to check your progress in achieving your business dream.

What can You do with a Budget?
We've already said that 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 profit and loss statement.

Right from the beginning you can use your budget to validate the activities you have planned for the coming year.

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. 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 a simple comparison of your budgeted figures to your actual results. Then begin by asking yourself "why" the are figures different. If some of your expenses, for example, 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? Don't fall into the trap of "blaming it on a bad budget." Use the information constructively and improve your budget the next time around.

A Plan for Increased Profit
An increase in profits should always be a consideration when you think about the future prospects for your small business. Before you can use a budget as a plan for increased profit, you have to be sure that your present profit is what it should be. 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 -- pay you a salary. Your budget can help you assess whether the rewards of being in business are adequate to compensate you for the risks.

Value of Owner's Service
Skilled crafts people who own service businesses are kidding themselves if their firms' profits are less than they can earn working for someone else. Your net profit after taxes should be at least as much as you can earn if you worked at your trade for a weekly pay check.

Return on Investment
The year-end profit is too low if it does not also include a return on the owner-manager'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 should check to be sure that the rate of return on your investment is what it should be. You wouldn't leave money in a savings account without a reasonable return and your business is no different. Your trade association should be able to provide guidelines about the rate of return on investment in your line of business. Your accountant and banker are also sources of help.

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. Your goal should also include an amount for state and federal taxes. For example, if you want to make $10,000 after taxes, your goal before taxes should be about $13,333. You have to add this $3,333 to take care of state and federal taxes. Keep in mind that the larger your goal, the larger the amount that will have to be added to cover your taxes. Your accountant can help you determine the tax amount or give you a tax rate to use for budgeting purposes.

Can You Reach Your Goal?
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 your required level of income.

Many businesses start with a forecast of profits and work up to a forecast of sales. Even large corporations can determine the required return on investment that shareholders require, then work back to planned revenue goals.

Alternatively, you can start with a sales forecast, but don't forget the bottom line must still give you the required return. In gathering your figures, keep in mind that without accurate information budgeting becomes guessing.

The owner-manager who has never budgeted should talk with an accountant about the process. You may need to make some changes to your record keeping 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 have a profit and loss (or income) statement at more frequent intervals to determine 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, cost increases, etc., always going back to your business plan to make sure you are addressing all the goals and activities you've planned. You will also need to approach fixed expenses a little differently than variable expenses.

Fixed Expenses
Regardless of sales, fixed expenses generally stay the same. Several examples of fixed expenses are insurance, rent, taxes on property, wages paid to salaried employees, depreciation of equipment, interest on borrowed money, building maintenance costs, office salaries and office expenses.

Variable Expenses
This type of expense varies with sales. In a product business, 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.

Revenue
The next step in preparing your budget is to determine and evaluate your required revenues (sales).

Step 1 is to calculate revenue from the figures you've already determined.

Step 2 is to 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 that many units with your current equipment? If the answers to these questions aren't favorable, then you need to go back and re-evaluate your plans.

Periodic Feedback and Control
A budget provides a tool for control. You start building this facility when your budget for 12 months is completed. Break it down into quarters, or better yet into monthly amounts. Such a breakdown 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 or quarterly budget provides you with one of the most important financial management tools.For example, by looking at next quarter's budget you can anticipate peak periods and schedule stock and labor to handle peak sales volume. You can plan vacations, special promotions, and inventory-taking for the slow periods.

A comparison of your monthly or quarterly profit and loss statement shows 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 or the quarter. Your objective is to guide your activities toward the most profitable type of operations and help you navigate the road to your business dream.

Recap of Key Points
In this lesson we have covered the following points:

Next Business Plan - Financial Plan
The Worksheet for Creating a Budget
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Return to Managing your Business Homepage