More than half of the year is now over, and if you are a non-profit, you might have just ended your fiscal year.
This is a great time to use your last 6 and 12 months of financial info to develop a budget for the next year.
Done right, you can make your budget actionable, use it to plan your year and hit your business goals.
What is a budget and why do I need one?
Simply put, a budget is a spending plan.
Without one, you run into the risk of spending too much or spending in the wrong places.
In that way, a budget gives you, your managers, and your employees permission to spend money in a specific way that supports the company’s goals.
The objective is to help you figure out how to get to where you want to go. You should be able to look at your budget and understand what needs to happen for those numbers to become reality.
Think of a budget as the GPS in your car.
If you want to get to a certain destination, you punch that destination in and the GPS gives you step-by-step instructions to get there.
A budget is the same.
You set your destination (your net income goal), make some assumptions, and your budget will tell you how to get to that net income goal.
Use budgets to help you:
- Anticipate upcoming spending needs;
- Spot issues before it’s too late to make a change;
- Create a plan to reach your goal;
- Solidify relationships with banks, investors, owners;
- Communicate with employees by giving them clear expectations of where the company is headed so that they can support those goals and be held accountable;
- Minimize risk;
- Project any cash shortages so you can start working on financing options ahead of time;
- Forecast revenues needed to support business costs, or start-up costs if you are just getting started;
- Set gross profit or net income goals;
- Make business decisions by investigating causes of budget vs actual variances and adjusting behaviors accordingly.
What does a budget include?
Budgets are simple and made up of four main components:
1. Fixed costs.
These are costs that don’t vary based on increases or decreases in revenue. Examples of common fixed costs are rent, insurance, and payroll.
2. Variable costs.
These are the costs that vary with production. Examples include raw materials, labor, and any energy needed to produce your product or service.
This refers to the money earned from the sale of goods or services. Revenue generally refers to all money a company receives from its normal business activities, usually from the sale of goods and services or other business transactions.
4. Net income or profit.
This refers to any money remaining after paying all costs. Another common number to consider is EBITDA, which is Earnings Before Interest, Taxes, Depreciation, and Amortization.
How do I create a budget?
One mistake people make is to use last year’s budget, copy the numbers over, and add or deduct where needed.
Last year’s budget should be used as a guide, simply to remind you of the costs you regularly incur. However, I wouldn’t use it to come up with your budget just yet. Your business might look very different in the upcoming year. If you use last year’s budget as a starting point, you might overlook new developments in the coming year.
Instead of asking yourself “what is different about my business this year compared to last year?”, think about what the future holds for your business and ask “what are my plans for this year?”. This is a key difference in thinking, and can make a significant impact on the accuracy of your budget, especially if your company is growing and changing rapidly from one year to the next.
So, how do you create your budget? Here are the six steps you should follow:
1. Net Income
The best place to start is at the end. Set a net income goal that is reasonable, achievable, and healthy.
- What is the average net income in my industry?
- What is a reasonable net income goal for my company?
- How much profit can I hope to make?
- What is a solid return on my investment?
Do your due diligence by using online resources or asking your trusted advisors (i.e. accountant, banker, etc) what other businesses in your industry are achieving.
You should take into consideration any major events happening in your industry, country, or even the world. Some examples can include losing a major customer, acquiring a major deal, or upcoming government elections.
Find a reasonable net income number for your budget and work backward from there. This will ultimately lead you to your final budget numbers for revenue and expenses.
2. Fixed Costs
The next step is to list out all of your fixed costs.
First, focus on unknown fixed costs by thinking about the year ahead. What new costs might you incur given the changes in your business and/or industry? Is there a trade show you’ll be attending for the first time? Will you be changing your marketing strategy? Does your website need a refresh? Think of potential fixed costs that you might not have incurred in the past. Talk to trusted advisors, including your accountant, banker, or others in your industry. You don’t know what you don’t know, so ask for help when you are entering uncharted waters!
Now, take a peek at last year’s financial statements to get a list of known recurring fixed costs. Remember, these are costs that should not fluctuate with changes in your sales or revenue in the next year. Some examples are salaries, insurance, rent, utilities, or maintenance services.
Once you have your list of known recurring fixed costs, consider increases in:
- Rent or insurance premiums
- Cost of living for your staff
- Utilities or service contracts
Once you have these costs, check them for reasonableness and compare your estimates to last year’s actuals. Adjust accordingly.
3. Variable Costs
Similar to the above step, list out your variable costs.
These costs fluctuate with revenues. Meaning the more revenue you make, the more costs you have. Examples include warehousing, inventory costs, or fuel for transportation companies.
Using last year’s numbers to get a list is a good start, but again, make sure to think ahead and ask your trusted advisors for guidance! You’ll want to list out any unexpected expenses that might come into play.
Once you have your list, determine how each cost will increase or decrease with fluctuations in revenue. Assign a percentage to each variable cost. That percentage should signify the portion of revenue that cost affects.
The actual variable costs will be determined once you put in your revenue budget.
Now for the fun part: revenue!
Since you already have your net income goal and all of your costs, your revenue is easy to determine.
It is simply the difference between your net income and all of your costs.
In other words:
Revenue = Net Income – (Fixed Costs + Variable Costs)
Once you have a revenue number, start digging into the details to determine if the numbers are achievable.
Break down the revenue number by product, business line, and/or client.
Come up with various scenarios by changing and manipulating the quantities and prices for your products and services to find the means to reach the revenue budget amount.
5. Make Adjustments
You should now have a sense if your initial budget estimates are realistic. If the revenue amounts feel outrageous, your net income or your costs are likely too high.
Moreover, if the implied revenue number is lower than expected, you might have forgotten to include a cost.
Tweak your net income, revenue, and costs to the point where they are realistic.
If your goal is to increase profits, your budget numbers should be slightly uncomfortable.
6. Break It Down
In order for your budget to be useful and actionable, you have to build it with sufficient detail. Start by breaking down your annual budget into months. This is especially important if your business is seasonal, if you are growing rapidly, or if cash is tight. Having a monthly budget allows you to compare your actual results to expectations regularly. Without this comparison, it will be impossible to take action and make business decisions to course-correct throughout the year.
Once you have a monthly budget, go one step further by breaking each cost down to a granular level. You should know exactly how each cost was derived. For example, your software cost budget should be broken down by software type, # of licenses, and monthly cost per license. This makes it possible to compare actual results to the budget components, determine the source of overages, and take action to impact future months.
Now that you have a budget, you should know what to do with it and how to use it.
How do I Use a Budget?
Your budget is a great tool to compare how your business is doing throughout the year. Armed with that awareness, use your budget to make business decisions and course-correct as necessary to meet business goals.
Compare your budget numbers to your actual results on a monthly basis. Look for significant variances, including both overages and shortages. From here, research the reasons why those variances exist. It’s important to really dig in and understand what specifically caused the variances so you can adjust your behaviors and actions accordingly. For example, did you spend more on software because your business grew and you needed more licenses? If so, maybe you can negotiate a lower per-license rate with your software provider. On the other hand, maybe you blew your software budget because the software company is charging you for bells and whistles you don’t need. Since you broke down your budget into those granular details, you have an actionable budget that you can use to inform your decisions!
It’s also entirely possible that your variances are due to inaccurate budget estimates. Perhaps you overestimated or underestimated some costs. Or perhaps your business has changed significantly in unexpected ways. Understand that your business, industry, and the world does change. If you find your business has changed significantly since you created your budget, consider taking a second pass at it mid-year. Otherwise, your budget will become useless and unactionable.
Budgeting Tools and Resources
Need help creating or updating your budget? Here are a few tools to get you started:
- The Business Owners Ideas Cafe. This site has a pretty simple budget calculator where you can plug in your startup monthly expenses in your first year of business.
- Microsoft’s free downloadable budget templates, including:
- A rolling budget;
- A small business expense budget tool;
- A website budget tool;
- An operating budget for a service business.
- The Corporate Finance Institute. This site offers some more advanced excel models and tools for budgeting.
Of course, we here at A La C.A.R.T.E. Solutions can also help you create or revamp your budget. Simply schedule a call and we’ll talk through how we can help.