A budget is a crucial planning tool for managing a business. Your annual budget will help you control costs and provide you with targets against which you can monitor the performance of the company.
A budget, though, is not a statement of what you want to happen; it is a realistic forecast of what you expect to happen. Some businesses, however, do create three different budgets to reflect the best case, worst case, and most likely scenarios.
So, where do you start the budgeting process, and how do you make your budget as accurate as possible? Here are twelve tips to guide you through the budgeting process.
1. Two Approaches
The first question you will need answering is where to start preparing a business budget. Well, you have two options. You can either begin the budgeting process by forecasting your costs and target profits and then calculating the sales you will need, or you can predict your sales and then adjust your expenses to achieve the desired net profit.
If your business has been trading for several years, you will have a history of sales to use as a baseline for a sales forecast. So, the top-down approach might be the best option. However, if you are preparing a budget for a start-up, your costs and target profit would likely be the best place to start.
2. Use the Right Tool
Most people prepare their budgets on a spreadsheet. The rows of your spreadsheet will be the same categories of income and expenses that you set up in the chart of accounts in your accounting software. The columns of your spreadsheet will be the months of the year. You can buy dedicated budgeting software, however it will take time to learn how to use a budgeting package, and spreadsheets are a more flexible tool.
3. Follow the Basic Accounting Principles
Your budgeted figures will be used in your accounting software for variance analysis. It is the variances from your budget that will highlight where the business is going off track as the year progresses. So, your annual budget should be prepared using the basic accounting principles to ensure that you are comparing like-with-like.
A fixed asset purchase, for example, will not appear in your budget, but the depreciation of that asset will. In other words, your budget is not a cash flow forecast. However, if you are running a small, one-person business, you may be running your accounts on a cash accounting basis. So, the budget and cash flow forecast might be the same thing.
4. Forecast Your Sales
As mentioned above, if you have a trading track record, you can start your budgeting process by looking at your sales figures’ history and trends. You could use last year’s sales by month as your base figure. And then adjust the figures for expected growth, price increases, and any changes to the products that are going to sell.
You will likely modify many of your forecasted figures as you go through the budgeting process. So, it is advisable to use formulas as much as possible in your budgeting spreadsheet. For example, your direct costs will probably be a function of the number of units you sell. So, calculating sales and direct costs via a formula based on units sold will make updating your budget much more straightforward.
5. Analyze Your Costs of Sale
Following the logical accounting order, your next port of call will be your cost of sale, or direct costs, which are the expenses directly attributable to what you sell.
If you sell products, then this section of your budget will include the variable cost of the production or fabrication of the products. Variable costs are expenses that vary in direct correlation to the volume of sales.
If you sell a service, your cost of sale will include the labor costs of the individuals who provide the service. If you use contractors, your direct labor costs will be variable. And if employees carry out the fee-earning service, those people’s basic salaries will not vary with sales; they will be fixed costs.
Other costs that you might include with the cost of sales would consist of shipping, packing, and sales commissions. And any additional costs directly attributable to the production and sale of your product or service.
6. Project Gross Margins
Your forecast sales less your cost of sales will give your gross margin. The gross margin is a critical number to know and monitor, because it will help you calculate the level of sales that you will need to make a profit.
7. Break Down Your Overheads
The next step in the budgeting process will be to look at the business overheads. Overheads are expenses like administrative costs, office rent, professional fees, and other costs not related directly to the sale of your products or service.
Overheads do not usually vary with sales volumes. However, if you are planning for significant expansion of your business, then you may have to account for what is known as stepped or semi-variable costs. For example, if the volume of sales increases beyond a certain point, you may need to employ another administrative employee to cope with the increase in orders and paperwork. If you need to hire several new admin employees, you may need to rent a larger office. Costs of this nature will increase overheads from the point that they are necessary and need to be accounted for in your budget accordingly.
8. Consider One-Off Costs
Although a budget is not a cash flow forecast, you will still need to account for significant one-off purchases that you are planning to make.
If the one-off purchases are fixed assets, though, then they will appear in your budget as an increase in your monthly depreciation charge. If you are expecting significantly higher accountancy fees at the end of the year, then that would be represented by a rise in the monthly accrued fees in your budget. Because you are following basic accounting principles in preparing your annual budget, you will be following the accruals concept and spreading one-off payments across the year.
9. Involve Budget Holders in The Process
If your business is large enough to have heads of departments, then it would be wise to involve those managers in the budgeting process. Involving managers in the preparation of your budget may highlight things that you would have missed. Management involvement will also increase buy-in to the targets that have been set.
10. Be Conservative and Realistic
A budget is a combination of a plan and a forecast. If you are planning to expand into a new market, you will need to forecast the additional sales, and you will need to include the additional costs that will arise because of that expansion. However, your sales forecast should be realistic, and your estimates of expenses should be on the prudent side. A conservative approach is the best way to create an achievable and realistic budget for your business.
11. Allow for External Factors
It would also be wise to consider that external factors might affect your business in the coming year. If you are aware that a new competitor has recently entered the market, then you may need to factor the increased competition into your sales budget. If inflation is on the rise, you should consider building that inflationary factor into your cost estimates. Of course, if there is a recession on the horizon, then that may dramatically affect your budget.
12. Be Flexible
You need to be monitoring your business performance against your budget throughout the year. If any of your budgeted figures vary significantly from the actuals, you may need to amend your budgeted figures to reflect the changes. It is helpful, though, to retain your original budget so that you can assess the accuracy of your forecasting at the end of the year. You do not need to amend your annual budget for every minor variance that occurs. However, your yearly budgeted figures do not need to be cast in stone if significant variances become apparent. Indeed, it is good practice to be flexible and periodically adjust your plans to reflect the current situation.
As you can see from the above, preparing a business budget is not a trivial task. However, if you spend adequate time on the budgeting process, it will prove to be an invaluable part of your business planning, and it will provide you with a means of assessing the performance of your business through the next financial year.