One of the main reasons many of our clients contact us initially is to gain a better understanding of their financials and what they are telling them. 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. If you are a start-up business, the process is a little tougher as you do not have existing financials and an existing run rate to rely on.
Benefits of Budgeting for your Business
Budgeting allows you to:
Before you start the budgeting process for your business, it is a good idea that you have your Chart of Accounts set up properly that reflects your operations. 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 a good time to sit down with someone and modify this before you get started. To set up a chart of accounts properly for a business, you need to understand the business.
Every business will differ on how your revenue is broken out. If you have multiple products or service types or other forms of revenue that you want to have an understanding of 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 want 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 that it is associated.
The cost of goods sold (COGS) are part of the cost of sales and are those direct costs that are tied to the production of goods sold by the company such as the cost of materials and any direct labor costs to produce the goods. The cost of goods are included in the overall cost of sales. If you are a manufacturing business or a retail business that buys products and inventories them, you have 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 any other expenses that are related to selling.
Be sure to discuss this with your accountant, so you understand what is relevant for your business.
There are many operating expenses that are the same for every business, but there will be some expenses that relate to your business. You also have to understand if they are paid every month or are paid once a year and know when they are paid. 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 even commissions. It is all very dependent 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, especially for operating costs that remain approximately the same, such as utilities or telephone. You will also 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, then you are starting at ground zero and is important 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 targets. As you are setting those targets, you need to understand what costs will increase to make that revenue, whether they are the cost of goods, outbound shipping, or even marketing. If the increasing volume decreases your cost of goods, then you need to understand the correlation when you set 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 make sure they are involved in the budgeting process. If you have a sales manager in your business who is responsible for sales, they need also to be part of the helping you budget your revenue. Larger businesses who have departments with managers should have each manager develop a budget that they provide to develop 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; 1) use last years numbers and increase expenses for inflation and sales growth, or 2) Bottom-up budget, (also known as zero-based-budgeting) where every dollar spent is scrutinized and justified based on the sales volumes that are anticipated (forecasted). Bottom-up will provide an owner with the most useful and relevant information and plan, however; it does take more time and effort. If your profits vary unpredictably, bottom-up budgeting is a good 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 make sure to enter your actuals for each month next to your budgeted amounts
Step 6 – Measure Your Performance
You want to make sure 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 need to revise your budget if you suddenly find there are large variances between your actuals and your budget. You may have overestimated your revenues and need to go back and edit the budgeted revenues to be more representative. Some businesses keep a budget (because it was board approved) and they create an ‘outlook’ which provides the same information. This way you can see how actual, outlook and budget compare with each other.
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 on a monthly basis. 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 you had not budgeted for this, you also need to increase the revenue in the budget as well. Once your actuals come in, you will be able to see if that spend actually helped you in meeting your revenue goal.
RK Fischer & Associates