Bizcoach, Small Business Ideas.

Budgeting Basics

Let's face it- nobody likes budgeting. Most people (especially entrepreneurs) would rather be out doing something, not sitting around trying to predict what's going to happen to next year's financials.

The truth is that it is not imperative for every company to have a budget. We have seen many well-run businesses without budgets and we're sure you have, too. However, we do believe that every company (especially growing ones) can improve its performance even further with a basic budgeting process. There are two simple reasons for this.

First, from a practical point of view, if your business is growing then you may soon reach the day when you need a budget- to apply for a bank loan, buy a new piece of machinery, raise capital from investors, etc. If that is the case, then it's far better to start a budget now rather than try to pull one together at the last minute.

Secondly, a budget is not about predicting the future- it's about making the future. Once you've made the effort to plan and visualize your company's financial results, then achieving them becomes that much more realistic.

What is a Budget?

Whenever you go on a trip, you fill your bag with the clothes, food, and money you'll need. That's the origin of the concept of budgeting- planning your trip and ensuring that you'll have enough resources in your bag to make it to your destination. In just the same way, an organization plans its trips- its strategic objectives- and prepares for the journey with an action plan called a budget.

While the budgeting process can get quite complex in large organizations, the starting point for most companies is to focus on two basic budgets: an operating budget and a cash budget. Typically, these budgets are developed to cover a one-year time span.

Operating Budget

The goal of the operating budget is to provide a blueprint for how the business is going to operate in the coming year. As a result, it pulls together information from functional areas such as design, production, marketing, distribution, and customer service. The end result is a budgeted income statement that shows how much profit the business expects to make at the end of the year.

Cash Budget

The cash budget is not as intuitive as the operating budget because it is strictly financial. However, it has a vital purpose: to ensure that the business has enough cash to fund its activities throughout the current period. Growing companies often find themselves strapped for cash even though sales are increasing and they are profitable. The goal of the cash budget is to ensure that you don't run out of cash. (For further help, see below- Seven Steps for Preparing a Cash Budget.)

The Key To Success

For example, let's say you are a food manufacturer and after the first three months of the year you want to evaluate how sales are proceeding. After reviewing the data, you discover that overall sales are lower than expected. Upon further research, you find that one of your product lines is 25% below budget due to a special promotion that your main competitor began offering to customers. This is where you would concentrate your corrective action because customers seem to be responding to the promotion, buying more product from your competitor and less from you.

Six Steps for Preparing an Operating Budget

1) Review prior period data.
Use historical data as a starting point. If possible, review your results for the past two or three years. Unless you are starting a new business or developing a new product (in which case there is no data to review), this will be the best indication of what's going to happen in the next year.

2) Develop reasonable assumptions.
After reviewing the data, you develop assumptions about the future. Trust your own experience and make educated guesses. What will sales growth be? Is the market for your products or services expanding? How effective will your marketing program be? What will your competitors do? Most business owners have strong sense of intuition about these things- listen to it, don't overanalyze. You can also gather information from trade journals or by talking with the people in your company who are close to the scene (members of the sales team, purchasing staff, etc.).

3) Determine expected revenues.
Use your prior period data and assumptions to make sales projections. Some companies establish a target that is realistic and attainable, others prefer a "stretch" budget that will be difficult, but not impossible, to achieve. However, it is important to keep your projections reasonable- within the constraints of production capacity or a limited sales force on the one hand, and customer demand on the other. Expected revenues include not only the number of products you expect to sell, but also at what price you will sell. If you plan to increase the price, do you expect customers to continue to buy at the higher price, or will sales decrease by some degree?

4) Calculate the expected cost of goods sold.
When calculating the cost of goods sold, be sure to include all direct and indirect costs: material, labor, packaging, storage, etc. Also, don't forget to take beginning inventory into account.

5) Calculate expected operating expenses.
This includes fixed costs such as rent, salaries, utilities, office supplies, etc.

6) Calculate expected operating income.
Presto, there's your operating budget.

Seven Steps for Preparing a Cash Budget

1) Determine the beginning cash balance.
Figure out how much cash will be available at the beginning of the period (year, quarter or month).

2) Add cash receipts.
Determine the expected receipts- collections from customers- that will flow into the cash account each period. Cash collections may vary during the budget period. For example, many retail stores expect to receive most of their receipts during holiday seasons.

3) Deduct cash disbursements.
Based on expected activity, calculate how much cash will be required to cover disbursements- cash payouts- during the period. Disbursements could include payment for materials, rent, payroll, taxes due, and so on. Some of these expenditures may be evenly distributed throughout the budget period, but some (such as material costs) may fluctuate as part of the production process.

5) Calculate the cash excess or deficiency.
To calculate the cash excess or deficiency for a period, subtract the disbursement from the sum of the beginning cash balance and the receipts expected during that period.

6) Determine financing needed for the period.
To calculate the cash excess or deficiency for a period, subtract the total disbursements from total cash available. If, at the end of the period, there is a cash excess, then financing of operations may be covered by the available cash. If, on the other hand, there is a cash deficiency, then you have to plan on financing the period�s cash needs from other sources, such as a bank loan or additional capital contribution. Note: remember to include a stable cash balance beyond the immediate cash needs. For example, a manufacturer may want to maintain a $20,000 cash balance at all times to cover unexpected cash demands.

7) Establish the ending cash balance.
The ending cash balance for each period will include the receipts and loans less the disbursements and financing costs. The ending cash balance becomes the beginning cash balance for the next period.