Budgets – why bother to do them?
Firstly, I would like you to rather think of this as a Forecast or Financial Plan rather than a Budget.
Once you have completed your business plan it is critical to then translate this into a financial plan. In practice, the financial plan should be part of the business plan. The “budget” or Financial Plan is not meant to be a document drawn up early in the year to please the banks or shareholders, but must be a working document and a realistic, well thought out “forecast” for the next one to three years.
Having a great business plan is all well and good but if you haven’t put the plan into numbers, how will you know if it is going to be financially viable? Business is primarily about money, and this applies even to a non-profit organisation. Therefore, there has to be a financial plan to achieve the business plan.
The Financial Plan (budget) will provide measures against which to track your progress and also, most importantly, highlight any potential problems that may raise their head in the future.
So what is the best way to draw up a budget?
- Firstly DO NOT simply take last year’s figures and add or subtract a percentage. This will only ensure that you keep on doing the same things and that will, in most cases, not help you grow.
- Set the sales forecast.
To do this accurately you will need to review every customer or product (depending on the type of business) and estimate how much you will sell to each customer. This may include discussing this with your customers, because the more accurate the sales forecast is, the better your overall budget will be.
Your business plan will dictate the way in which you want to grow and/or change your sales and the forecast should reflect this plan. A sales forecast must always be set at a challenging level because you want to grow in your business. However, it should also be realistic, as should your entire business plan.
- Set the Cost of Sales to determine your Gross profit.
For a manufacturing, wholesale or retail business you will need to determine what the cost of your products will be and what you can sell them for i.e. your gross profit margin. Again this must be realistic. For example, if you decide that you are going to increase your margin by 5%, but the market will not accept the required selling price increase to achieve your 5% margin growth, then you will only be fooling yourself about the level of profit you expect to make.
If yours is purely a service business, then the gross profit margin does not apply as you will only be selling time. There are a number of businesses that supply both goods and services and you will need to look at these two areas separately.
- Decide on the people you will need.
Having set your sales forecast and gross profit forecast, the next step is to decide on the people that will be needed to meet the sales, produce the goods, man the warehouse, deliver the goods, administer the business etc. While this may not change every year it is important to review the people you have and who you may require in the future. This will give you time to upskill your current staff if required or to start looking for new staff.
The salary that you pay must also be reviewed to decide on increases, and to check that you don’t lose key people because you are not paying them enough. Conversely to check that you are not overpaying.
- Set your overhead forecast.
This is where it is very tempting to simply take last years expenses and add on a percentage. The very real danger of this is that if you are incurring unnecessary expenses you will then continue to incur them.
It will take some time and effort but I recommend that you go through each and every expense and review whether it is necessary. Can it be eliminated or reduced? Cost control is vital to any business and even the smallest expenses must be checked as these can quickly grow if left unchecked.
- Finalise the forecast.
Once you have completed all the elements of the forecast then put this into a monthly income statement forecast, so that you see at a glance what you plan to make for the year and if it is meets your expectations. If not, then you can review the forecast and decide what actions to take to get the business back on track.
Finally, this forecast will be the foundation for drawing up a cash flow forecast. See the article on cash flows on how to go about estimating your cash flow. AND DO NOT simply put it in your bottom draw. As with your business plan this is the document you must use to constantly monitor how the business is performing and then take the necessary actions if it is going off track.