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March 2006 Company budget an essential tool for maximizing profits A properly created and managed budget is a responsible “silent partner” determined to keep you on the right track Many business owners understand the need – at least in principle – to create an operating budget, but their good intentions often fall victim to the pressures of day-to-day management that leave little time for planning and analysis. That’s unfortunate, because allowing the preparation of a company’s operating budget to languish near the bottom of the priority ladder deprives you of a powerful management tool. Why budget? A budget tells you whether or not your income, spending and profits are on track. If you experience unexpected windfalls or expenses, your budget acts as an early warning system. And, of course, a budget can be essential to satisfying a lender, bringing on new partners, and attracting investors. A budget is one of the most fundamental and essential tools of starting, growing or maintaining a business, whether you are a sole proprietor or own a corporation with a thousand employees. With a budget, you’ll have a history of performance that allows you to show what you planned to do with your company and what you have achieved. The more detailed your budget is, the better off you generally will be. In fact, a budget should be partnered with an extended cash flow system, and both should be updated and projected on a consistent basis. The fundamental purpose of the budget is to examine, as accurately as possible, if the business revenues will cover or exceed its expenses. Therefore, an effective budget should have, at the least, two main components: a revenue forecast (i.e., income from sales, investments, etc.) and an outflow forecast, including non-expense items such as loan repayments and capital purchases. A budget is the key to cost control and to your company’s success and profitability. A budget, if used and updated regularly, will help you recognize if you are both profitable and stable. A diligently maintained budget and cash flow system – structures that are utilized, updated, evolved and reconciled – lets you better understand your company and seize control of your future profits. A budget also allows you to take action, sooner than later, if a future month or months appear unprofitable. Although accountants, other financial advisors, and software programs are surely valuable resources in a well-run business, one could argue that the most powerful and useful training you can give yourself as a business owner is internally managing your own numbers. Crafting a budget does away with fanciful thoughts about the future of your business and forces you to think through every action you take and how it affects your bottom line. A budget will help you to make decisions about spending money, establishing prices, seeking certain profit margins, hiring and firing employees and so on. In many ways, it is a silent partner with a cool head determined to keep you on the right track. Budget mistakes. Your budgeting philosophy should reflect conservatism, especially on the income side. At the same time, you don’t want to be so rigid or conservative that your budget practices prevent your business from seizing good opportunities. Another common mistake is not putting in the right amount of detail, or having some key elements in there but getting bogged down when it comes to making projections. Don’t worry too much about absolutely accuracy; you’re not building a road, just a road map. Many entrepreneurs need help with their budgets but don’t ask for it. Having a CPA or other financial advisor help you prepare a first-time budget can be a smart idea. After that initial budget is drawn up, you should be able to manage it, with your professional advisor waiting in the wings, especially as the end of your fiscal year approaches. Once you have committed to create a budget, don’t treat it as a one-time exercise. Consider it a living document that you use to run your business day to day. Often we see entrepreneurs who have prepared budgets, but only to satisfy a lender or meet some other short-term expectation. After investing the time and effort of drawing up the budget, they set it aside and never consult it again. Creating a budget. The typical budget cycle starts approximately three months before the beginning of the company’s next fiscal year. The company assembles historical information – financial operating results for the prior three to five years as well as current information for the last nine months. This historical information is analyzed for cost relationships (for example, cost of sales as a percentage of sales revenue) as well as for trends (for example, medical insurance costs have been increasing at a rate of 10% per year for the past three years). As you start, itemize your projected revenues and expenses based on the historical averages or trends, and then start forecasting at least 12 months into the future. Each month should be considered singularly, taking into account variations in revenue expectations (i.e., seasonal fluctuations, product or service variances, etc.) as well as expenditures that are fixed, variable, and semi-variable. You should forecast monthly unit sales by product and/or service, and then apply projected unit sales prices to obtain monthly sales revenues. Using both the historical cost relationships and trends identified above along with expectations of anticipated changes (for example, if a major supplier just increased the price of certain raw materials), the cost and expense elements of the budget are calculated. This then yields a projected income statement and statement of cash flows by month. These projected statements are further analyzed. If the projected net income is lower than desired, you must increase revenues or cut expenses or both. If the statement of cash flows indicates there will be insufficient cash to support operations at some point, then arrangements must be made to obtain short-term financing or the budget must be adjusted to eliminate the negative cash flow. Many software products are available for budgeting. The program you select should, above all, be fairly easy to learn and use. It also helps to have software that’s formulated for small business owners. Industry-specific software may be available, too (your trade association may be a good source of guidance), but don’t get hung up on overly specialized budgeting tools. A general program may work just fine and be easier to use. Maintenance. Go over your budget every month and examine your cash flow to make certain your available funds will meet your liabilities. Reconcile the budget to what really happened, and determine where the differences, if any, occurred. This will also assist you in becoming more realistic and accurate regarding your future months’ projections. If you’re adjusting your budget as you go, you’ll have some sort of emergency fund to take care of monthly overruns. Use it when things cost more than you thought, and put money into the contingency fund if you come in under your expected numbers. Final thoughts. Be prepared to miss your budget estimates and act accordingly, recognizing that your budget projections are a best guess and nothing more. Use your budget as a form of restraint, not constraint. Setting up and sticking to a solid budget is the most effective teacher of fiscal discipline there is, but don’t be shy about busting your budget on occasion should something truly warrant it. A good budget is great, but don’t let it dictate your business. With all the technology and professional
resources available to you, your excuses for postponing the budget process
are rapidly dissolving. Once you start, you’ll be glad you did. And when
you’re finished, your biggest question will be, “Why didn’t I do this a
long time Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |
