Most businesses, particularly small businesses which fail within the first year or two of operation, do so because they have not taken the necessary steps to plan and manage their finances.
Budgeting should be done a regular basis, but is critical at every important turning point that your business meets, for example, when considering investment in new equipment, a new lease or when contemplating expansion. Regular and accurate budget preparation will help you determine your available capital, whether you have sufficient funds to achieve your business goals and if not may highlight appropriate steps to allow you to gain and maintain control of your business.
What is a budget?
A budget is a forecast of all of the business income and expenditure, including all income streams.
Creating an annual budget is generally the most effective way to plan for the coming financial year. Annual budgets can then be divided into monthly budgets and reviewed on a quarterly basis to monitor income and expenditure.
Creating a budget for your business will help you:
- Plan for the future
- Monitor your business performance
- Identify areas where you may be overspending or losing money
Review your budget regularly by comparing estimates with your actual profit/loss statement to identify problem areas and avoid potential future financial pitfalls.
The budget equation
The basic budget equation states that:
Income – Expenditure = Profit
To determine an initial amount for your budget, there are three main areas to consider; your business’s sales income, including all possible income streams, the total business expenditure for the budgeted period, and your estimated profits.
When collating income figures for the period that your budget will be covering, make sure that you consider all of your business’s income streams. While sales figures will most often make up the bulk of your income, you should also take into account any interest, dividends, royalties etc. that your business may receive. Any form of regularly received income will count toward your business’s overall income. Estimate your income based on previous figures whenever possible, while also taking into account the current economic climate and recent sales trends. Try to make your estimates as accurate as possible to increase the efficacy of your budget. Once you have estimated your business’s income for the budgeted period, you can calculate the necessary expenses required to achieve your goals,to determine if you can afford to pursue them now, or plan a realistic timeframe.
Your business’s overall expenditure for your budgeted period will include all fixed and variable costs, and may also need to take into account inflation and other adjustments, depending on the length of time your budgeted period covers.
Your business’s fixed costs are payable amounts that will not change by any significant amount throughout the time allotted by your budget, regardless of how your business is performing. Costs such as rent for office space and equipment are fixed for a specified period by the terms of the rental agreement and cannot vary within the agreement period. These can be estimated accurately based on such agreements.
Costs that will change significantly within your budgeted period are your variable costs. It is more difficult to estimate variable costs, as they can change based on a number of factors. Some examples of variable costs are your business’s product stock, which can vary greatly depending on your sales and on market prices for materials, transport costs, which will also vary based on your sales, and utility bills. A realistic estimation of these costs should be based on previous payable accounts and predicted sales.
If your budget is covering a period of one or more years, you will need to take into account the rate of inflation when estimating your variable costs. The price of goods and services, such as stock and transport, can increase based on annual inflation rates. Therefore it is important to consider these rates when budgeting to ensure your costs are estimated as accurately as possible.
Ideally, your business’s profits should be high enough to make a return on investments, as well providing you with a fair return on your labour. Achieving a return on capital invested in your business by parties other than yourself should be your first priority, in order to satisfy your investors. Personal investments, including the amount of money that you put into your business as start up capital, and the profit from previous years that you have reinvested into your business, should be your second consideration. It is also important that you receive a return on the time and effort that you have put into the business. The amount that you pay yourself on a weekly, fortnightly or monthly basis should reflect your potential earnings if you were working for someone else.
Using these concepts and the basic budget equation, you can estimate your budget for a specified period and plan how to manage your business’s finances, allocating funds appropriately and estimating profit, in order to determine whether or not your business goals for the future are achievable. When setting your budget, remember that it is always safer to over-estimate costs and under estimate profits.
Constructing your budget
For practical purposes, most small businesses will forecast their profits for a specified period when creating their budget. Once you have determined the profit amount you can calculate the expenses that will be incurred in order to make the profit amount and the income that will need to be generated in order to cover the amount of expenditure.
To construct your budget step by step, you will need to:
- Target desired profit: Estimate the amount that your business needs to make in order to provide a return on financial and labour investments.
- Determine operating expenses: Calculate the expenditure required to provide your desired profit, taking into account fixed and variable costs, as well as inflation rates.
- Calculate gross profit margin: The gross profit margin will be the sum of your net profit and your total operating expenses.
- Estimate total income: Determine the amount of total income required to achieve your gross profit margin, taking into account the cost to your business of the goods sold to reach your target amount.
- Adjust figures: If the calculated figure for your business’s total income is realistic and achievable, your budget is complete. However, if this amount seems problematic, your desired profit margins and operating expenses will need to be adjusted accordingly.