Budgeting: Under-appreciated and Under-utilized

One of the last things that most small business owners consider is doing a Budget. A large number of owners do not understand the value obtained from a having a budget. Often, when budgets are in place, they will not take the time to review them regularly or use them as a tool to guide them in the management of the Company.

Many owners look at their plan for the year as “it is what it is” regarding the sales and profits that are to be obtained for the year. They will settle for what the year brings them. We know this is flawed thinking, particularly if increased sales and profits are necessary or needed to meet your goals. A budget when used appropriately will help to guide the owner to achieve his goals.
Some of the owner’s reluctance may be rooted in the fact that his Chart of Accounts is inadequate and we have failed to discuss this or to emphasize this factor. In other words, if his Revenue and Cost of Goods are one-line items in the P & L and he does not show any revenue streams and does not track labor or materials separately; the potential value is hidden from him at this time. He cannot see that tracking these items separately and in a forward-looking budget will produce a benefit.

An additional problem may be that even if a budget is developed, there may have been not enough time spent to train people properly on the value of a budget and what it can do for strategic planning.

REASONS FOR A BUDGET

1. Statement of goals and methods of reaching them.
2. Defines priorities and boundaries for spending.
3. Sets goals for Sales and Marketing
4. Ensure that a proper amount of money is allocated for salaries, expenses, and profits.
5. Gives the ability to monitor under-performing areas and address them before they create major problems.
6. Ability to monitor Cost of Goods concerning Revenue and Fixed Expenses and light of past expenditures and the current Revenue.
7. Assists in the decision-making process of when to make capital expenditures.
8. Assist in the evaluation of the realities of the goals that have been established.

PRELIMINARY CONSIDERATIONS

As noted before, the first step must be a review of the Chart of Accounts :

1. Do we have several Revenue streams that should be tracked separately? If so, new accounts must be created in the COA to enable them to be tracked individually.
2. Are the Cost of Goods separated into Labor, Materials, Equipment, Supplies, Fuel, etc? If not, new accounts must be created here as well. (Remember these are all items “directly billable to the jobs”)
3. Are there items in fixed expenses that need to be moved to Cost of Goods? Usually, some of the items are COG and need to be allocated as such.
   1. It would be ideal to get at least three years of previous monthly sales and determine the average percentage of sales for each month.
   2. Once revenue goals have been determined we can then break this down into the seasonality revenue by each month.Is there seasonality in the business? Does one month or one quarter contribute a larger portion of the Revenue?

NEXT PHASE

5. Make a realistic estimation of the amount of profit desired or necessary.
   1. What does the business require?
      1. What would be a reasonable return on the investment?
      2. What do the stakeholders feel needs to be a reasonable return for their efforts.
   2. Fixed Expenses
      1. Fixed expenses usually remain the same regardless of the revenue. These are the expenses incurred whether we open the doors or not: items like rent, electricity, heat, insurance, licenses, interest, office salaries and office supplies.
      2. A cost of living increase, at the very least is required but in some cases (electricity, insurance, health insurance) a larger increase maybe warranted.
      3. Take into consideration any predetermined (rent, health insurance) increases for the upcoming year and any increases in the advertising or marketing budget above the previous level.
   3. Determining Revenue
      1. In establishing a budget, some will guess at the expected revenue or set the desired number that might not be achievable. However, we may be a bit more methodical if we start with our fixed expenses total and add our desired or required profit to that number.
      2. If we assume that we have increased our fixed expenses as well as our desired profit; and we assume that the Gross Profit percentage will remain about the same we can calculate the desired revenue to achieve the profit level we want.
         1. Having previously determined the new amount of fixed expenses we add to it the amount of profit also desired.
         2. If our historical Gross Profit is 28% we can calculate the amount of revenue needed to support the fixed expenses and profit level
         3. Take the combined total of fixed expenses and desired profit and divide by the gross profit percentage to arrive at the revenue required.
         4. EX. $180,000 fixed
         5. $100,000 desired profit
         6. $280,000 Total divided by the GP%. Thus $280,000/.28 =$1,000,000 or the required revenue goal for the year.

         Variable Expenses

      3. These costs will vary with the amount of revenue that is generated and they are the direct costs of doing business. Crew Labor, materials for the job, truck repairs and maintenance, truck fuel, workman’s compensation for the crew labor and supplies
      4. If previous year’s numbers are available, we can use the percentage of revenue that each expense formed as part of the overall revenue. Thus, if labor wages were 50% of revenue that would probably be a valid number for that segment of the COG in the new budget. This process should be repeated for each account in the Cost of Goods.
         1. Take into account the necessity for an increase or decrease in the number of laborers based on the revenue goal.
         2. How much of an increase do we get due to the revenue increase?
         3. Generally from year to year the percentages will be within a small range, unless a new revenue stream is developed or windfall of new work is landed.
      5. Review and Compare
         1. Look at the totals for the fixed and variable expenses and the desired profit.
            1. Then the next question asked should be, ” is that amount of revenue attainable?”
            2. If not, what are the realistic reductions in the fixed expenses or is the desired profit too high?
            3. Make Adjustments.

SUMMARY

1. The budget should paint a picture of the future financials for the company.
2. Setting your profit goals on paper (or electronically) will ensure that you will be more likely to attain those goals and they will not evaporate.
3. Trying to achieve a goal without a budget will almost ensure that your goals will not be met.
4. Budget to ensure an adequate return on your investment.
5. Monitor the budget monthly to see that the revenue and expenses are in line so that your profit goals will be met.

At Cogent Analytics, we never stop looking for ways to improve your business and neither should you. So, check out some of our other posts for helpful business information: