One of the main reasons many of our clients initially contact us is to understand their financials. One of the best ways to do that is to start with the budgeting process, as it provides you with an understanding of your revenue, your cost of goods (it also helps you understand what drives costs in your organization) and your operating expenses. The process is a little more challenging if you are a start-up business as you do not have existing financials and a current run rate to rely on.
Benefits of Budgeting for your Business
Budgeting allows you to:
Get a better handle on your cash flow.
Determine how your business is performing financially and gain insight into your financials to help you make sounder decisions
It helps you plan for the future of your business.
It helps you manage your goals and objectives for your business.
It helps you understand what drives costs in your organization.
Before Your Start Budgeting
Before starting the budgeting process for your business, it is a good idea to have your Chart of Accounts set up correctly to reflect your operations. To properly set up a chart of accounts for a business, you need to understand the business. If you are working off a default chart of accounts for your business that you were not involved in with your bookkeeper or accountant, now is an excellent time to sit down with someone and modify this before you get started.
Every business will differ in how its revenue is broken out. If you have multiple products or service types or other forms of income that you want to understand how each is performing, you will want to break those out separately. It could be as easy as Products, Services, Subcontracting, and Interest Income. If you wish to have sub-categories, that is perfectly fine as well.
Cost of Sales
Depending on your business, your cost of sales (COS) will differ, so you may want to break out your cost of sales so that you can track it as it directly relates to the revenue in which it is associated.
Cost of Goods Sold
The cost of goods sold (COGS) is part of the cost of sales. They are the direct costs tied to the production of goods sold by the company. This includes the cost of materials and any direct labour costs to produce the goods. The cost of goods is included in the overall cost of sales. If you are a manufacturing or retail business that buys products and inventories them, you have the cost of goods sold (COGS).
If you are a services business, you will not have the cost of goods sold, but you may have a cost of sales (COS). The cost of sales items could include commissions, shipping and delivery, and other expenses related to selling. Discuss this with your accountant so you understand what is relevant for your business.
Many operating expenses are the same for every business, but there will be some expenses that relate to your business. The level of detail for your operating expenses depends on how you best want to track various expenses and delve into them. For example, You might have Wages, but you probably want to break out salaried employees from hourly employees along with the relevant taxes and commissions.
You also have to understand if the expenses are paid monthly or once a year and know when they are paid. It all depends on the level of detail you want to understand about your business.
Once you have the Chart of Accounts set up for how you want to run your business, you are ready to start.
The Budgeting Process
Step 1 – Historical Data
As mentioned earlier, if you are an existing business, you can run a profit and loss statement from your accounting system to provide you with some historical data. This is especially true for operating costs, such as utilities or telephone, that remain approximately the same. You will want to have an understanding of last year's revenues and cost of goods as well. If you are in a seasonal business, you will be able to see how the seasonality affects your net income. If you are a start-up, you are starting at ground zero, and it is essential to understand your business enough to forecast revenues, understand your cost of goods, and know approximately what your operating costs will be for the first year by month.
Step 2 – Set Realistic Revenue Targets
If you are looking to increase your revenue, be sure to set realistic revenue targets. As you set those targets, you need to understand what costs will increase to make that revenue, such as the cost of goods, outbound shipping, or even marketing. If the increasing volume decreases your cost of goods, you need to understand the correlation when setting up your budget.
Step 3 – Make Sure Right People Are Involved
If you have departments or individuals in your business who have the authority to spend money, you will want to ensure they are involved in the budgeting process. If you have a sales manager in your business who is responsible for sales, they also need to be part of helping you budget/forecast your revenue. Larger firms that have departments with managers should have each manager develop a budget that they provide to build the company's budget. The owner has the final say, but getting input from others can help with accuracy.
Step 4 – Establish the Budget
There are two ways to create a budget:
Use last year's numbers and increase expenses for inflation and sales growth, or
Bottom-up budget (also known as zero-based budgeting), where every dollar spent is scrutinized and justified based on anticipated sales volumes (forecasted).
Bottom-up will provide an owner with the most valuable and relevant information and plan; however, it does take more time and effort. If your profits vary unpredictably, bottom-up budgeting is an excellent process to follow to gain betting insight.
Step 5– Enter Your Actuals at the End of the Month
If you are not using an Accounting System with a Budgeting Module, you want to enter your monthly actuals next to your budgeted amounts.
Step 6 – Measure Your Performance
You want to calculate the variance (the difference) between your budget and your actuals for each month, quarter, and year.
How are you performing to your budget?
Are your expenses more than you expected, and if they are, do you know why?
Step 7 – Review Your Budget and Revise It As Required
You may have overestimated your revenues and need to go back and edit the budgeted revenues to be more representative. You may need to revise your budget if you suddenly find significant variances between your actuals and your budget. Some businesses keep a budget (because it was board-approved) and create an 'outlook' that provides the same information. This way, you can see how actual, outlook, and budget compare.
If you budget and measure the variance to the actuals for your business, you will begin to get a better handle on how your business is performing and what is affecting your cash flow monthly. There are only two ways to improve your cash flow position in your business. One is increasing revenues, and the other is reducing expenses. Having a budget to guide you will help you to make more informed financial decisions for your business.
Budgeting is not meant to be confining, and budgets can be modified. If you need to increase your online advertising to increase revenue but had not budgeted for this, you also need to increase the revenue in the budget. Once your actuals come in, you will be able to see if that spending helped you meet your revenue goal.
If you need help budgeting for your business, this could be accomplished through business coaching if you want to learn how to do it yourself, or through financial management if you would like to have it done for you.