Budgeting

Budgeting, whether for the home or the business, is a management tool for dealing with the future. It helps you turn expectations into reality. More often than not, homeowners, and businesses, don't prepare an annual budget; and often wonder why reality does not meet their expectations.

As homeowners and businesses work into a new year, a review of budgets and budgeting is appropriate. Let's illustrate some of the basic principles of budgeting for the small business.

My Teaching Lesson

Some years ago when I was instructing a group of graduate students in the foundations of financial administration (yes, it did seem boring to some), several students approached me and wondered when I was going to teach them "Budgeting 101." How did they get this far in life, I wondered, without knowing how to budget?

We took several lunch hours over the blackboard (yes, they were still in use then) to develop a real budget. So I asked them some very sophisticated questions - Do you have a checking account, a savings account? What do you use your checking account for - daily, weekly, monthly expenses and bills. What do you use your savings account for - major house repairs, major purchases, and, oh yes, saving for the future.

It did not take long for my charges to get the message - add up all your weekly expenses, month by month for the past year. You will see a pattern of expenses - cable bill, electric, gas/oil, water/sewer - your utilities, groceries, clothing, supplies, insurances, etc.

Now that you know what you have spent on regular, recurring items, when do your "discretionary" expenses occur? Why do you decide to purchase them? How are they related to your family needs, your lifestyle needs, and your "splurge" needs?

Once you can answer these questions, you know several things - how much you need in "take-home pay" to pay for these expenses on a monthly basis, as well as the motivations behind your spending patterns. You may also then have the ability to make some choices on those discretionary items (change your priorities), or lower the thermostat, water the lawn less, or become more of a coupon shopper.

And if you can lower your payments and/or increase your take home pay, you can leave more in the bank!

One of my students acknowledged he finally understood all about budgeting! And I did not even relate it to business. Oh well, perhaps in retrospect the class was boring.

For business, budgeting is not very different. As businesses begin to wind down their fiscal year, their first consideration for the next year should be about the prospect of increasing their profit for their business. Working up a budget helps them to determine whether their profit goal is within reach.

First Steps - Collecting Data

So, let's get started. Collect all your fixed costs and your variable costs for the past year.

Regardless of sales, fixed costs stay the same. Several examples of fixed expenses are insurance, rent, taxes on property, wages paid to salaried employees, depreciation of equipment, interest on borrowed money, building maintenance costs, office salaries, and office expenses.

Variable costs vary with sales. In some businesses, the cost of labor is the biggest factor. Sales commissions, payroll taxes, insurance, advertising, and delivery expenses are other examples of variable expenses.

Break them out and organize them on a monthly basis - November through October. Next, we will look at how these fixed and variable costs can create a budget, and, more importantly, lead to the creation of a more profitable business.

Analyzing Your Data, Making Some Assumptions

In the last step we asked business owners to pull together a full year's fixed and variable costs/expenses so that we could begin to create budget and create a more profitable business. From these three figures - profit, fixed expenses, and variable expenses - you can determine your "hoped for" total income.

When the figures are all together, you have answers to questions such as: What sales will I need to achieve the desired profit? What fixed expenses will be necessary to support these sales? What variable expense will be incurred in producing the product or services?

Because business is not a cut-and-dried affair, the first budget often will uncover issues and suggest choices to you. Working up alternative budgets will help you decide what changes you will need to consider in order to have a workable plan for next year.

Many owners run their businesses without a planned goal. In trying to survive from week to week and from month to month, owners overlook an important management tool - budgeting. Whether the plan is for next year, for the next 3 years, or for the next 5 years, budgeting can help you just as a map helps you to keep on the right road.

A budget in its simplest form is a plan that enables you to set a goal and list the steps that are necessary to reach that goal. A budget helps you think about what you want your business to do in the future (remember our discussion about making choices, and setting or changing your priorities?) By planning, you are in a better position to act to prevent problems from developing.

A budget is a detailed plan of future receipts and expenditures - a projected profit and loss statement. Once the period for which you have budgeted is completed, you can compare actual results with anticipated goals. If some of your expenses, for example, are higher than you expected, you can start looking for ways to reduce them. Conversely, if you have fallen short of your goal, you may want to look for ways to increase your income.

You can start either with a forecast of sales and work down, or with a forecast of profits and work up. Most businesses use the latter method. In other words, you decide what profit you want to make and then list the expenses that you will incur in order to make that predetermined profit. You will need to realistically ask the question - Can I achieve this goal and how?

Before you can use a budget as a plan for increased profit, you have to be sure that your present profit is what it should be. In a business, the year-end profit should be large enough to make a return on your investment and a return on your own work-pay. This may seem difficult to determine, but if you have collected your expense data, you are well on your way to identifying this.

For those business owners who are skilled crafts people - you are kidding yourself if your companies' profits are less than what you could earn working for someone else. Your net profit after taxes should be at least as much as you can earn if you worked at your trade for a weekly paycheck.

So, after you review your fixed and variable expenses, prepare your forecast for next year - a forecast of sales or a forecast of profit. Spend some time preparing your assumptions (forecast). And write them down. Now, let's pull this information together.

The Final Step

In the last two segments we asked readers and business owners to begin the necessary steps to preparing an annual business budget. Now we will tie it all together.

By now, you should have collected and analyzed your fixed and variable expenses and prepared a profit forecast - either based on sales or on profit.

Your year-end profit will be too low if it does not also include a return on your investment. That investment includes the money you put into the company when you started it and the profit of prior years that you left in the company - often called retained earnings.

After you know what you made last year, you can set a profit goal for next year. Be sure that your goal includes a return on your services and a return on your investment.

Once you have decided on your profit target, the next step in preparing a budget is to determine whether you can achieve this. To do this, you need to project your fixed expenses and your variable expenses. From these three figures - profit, fixed expenses, and variable expenses - you can determine your "hoped for" total income.

In reviewing the data collected, keep in mind that without accurate information, planning becomes guessing. If you have never budgeted before, you may benefit from a blackboard session on "Budgeting 101," and a review of your record keeping system. Changes in your record keeping system may be needed to provide the necessary budget information. It may be that your present accounting software or system does not break costs down into fixed and variable expenses, or it may be that you need to have a profit and loss (or income) statement at more frequent intervals to determine the seasonal fluctuations of your revenues and expenses.

Let's assume however, that you have the ability to conduct a good analysis. Your expected income contribution is the difference between sales and the variable expenses that are necessary to produce these sales. When this difference equals fixed expenses and the desired profit, you have a workable budget.

Your developed budget provides you a tool for control. You start building this control tool when your budget for 12 months is completed. Break your budget down into fiscal quarters. This type of breakdown allows you to check for any discrepancies that may not show up readily in a 12-month budget. When many items are added together, it is easy for an error to creep into the totals.

During the year, this quarterly division provides a handle for managing expenses and other activities and also helps you to understand expense and income variations.

For example, by looking at next quarter's budget you can anticipate peak periods and schedule stock and labor to handle peak sales volume. You can plan vacations, special promotions, and inventory taking for the slow periods.

A monthly or quarterly profit and loss statement allows you to keep the items in your budget in line with operations. Then compare the actual and the planned revenues and expenses on the income statement.

Once you run through this process several times, you will be better able to pinpoint and work on the problems that have occurred during the month or the quarter. Your objective is to guide your activities toward the most profitable type of operations.

Successful businesses make budgeting a regular habit. The more regular the habit, the more successful you r business will be. Happy budgeting!