Budgeting in a Small Business
BASICS OF BUDGETING
LEARNING BY EXAMPLE
RECAP OF KEY POINTS
Many owner-managers run their businesses without a planned goal. In trying to survive from week to week and from month to month, such owner-managers overlook an important management tool -- budgeting. Would you ever consider going on a journey without determining what supplies you might need, the mode of transportation or how to take care of things at home while you're away? Of course you wouldn't. Why then would you set off on one of your most important adventures, starting or managing your business, without a clear picture of what's ahead and what resources you'll need to get there?
Whether the plan is for next year, for the next three years, or for the next five years, budgeting can help just as a map helps you keep on the right road. Once you've developed your business plan, preparing the first budget is easy -- think of your budget as the "financial picture" of your future.
Because small business is not a cut-and-dried affair, the first budget you prepare often uncovers problems with your plan and helps you determine whether or not your financial goals are within reach. The budget will also help you focus and select from alternatives so that your plan is realistic and achievable.
When the figures are all together, you have answers to questions such as: What sales will be needed to achieve the desired profit? What will the equipment that is needed cost? Can you afford the marketing and advertising that you outlined in your plan? And many more.
And, when you complete your budget you will have one of the most effective management tools of all -- something that you can use each and every month to check your progress in achieving your business dream.
First we'll cover the basics of budgeting for a small business and then we'll provide you with an example that illustrates the principles of budgeting in a small business. Let's begin by discussing why you need a budget...
WHAT CAN YOU DO WITH A BUDGET?
We've already said that a budget is a translation of your business plan into "numbers." In its simplest form a budget is a detailed plan of future receipts and expenditures - a projected profit and loss statement. Right from the beginning you can use your budget to validate the activities you have planned for the coming year. Will you be able to afford additional staff? Do you need to expand your facilities or equipment? When will be the best time to start your new sales campaign? Do you have a period where sales are slow and making ends meet is a challenge? Knowing what all your business activities will cost and when such expenses will occur will help prevent any unexpected surprises that could lead to financial problems.
Once the period for which you have budgeted is completed, you can compare actual
results with anticipated goals. Get into the habit of making this a regular part of your
business routine. You may find it takes discipline at first, but the rewards are high. You
don't have to do anything elaborate-- just a simple comparison of your budgeted figures
to your actual results. Then begin by asking yourself "why" the are figures
different. If some of your expenses, for example, are higher than you expected, do you
need to look for ways to cut them or has business increased? If your sales aren't on
track, what has happened to cause the difference? Don't fall into the trap of
"blaming it on a bad budget." Use the information constructively and improve
your budget the next time around.
A PLAN FOR INCREASED PROFIT
An increase in profits should always be a consideration when you think about the future prospects for your small business. 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 small business, the year-end profit should be large enough to make a return on your investment and return on your own work -- pay you a salary. Your budget can help you assess whether the rewards of being in business are adequate to compensate you for the risks.
VALUE OF OWNER'S SERVICE. Skilled crafts people who own service businesses are kidding themselves if their firms' profits are less than they can 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 pay check.
RETURN ON INVESTMENT. The year-end profit is too low if it does not also include a return on the owner-manager's investment. That investment includes the money you put into the firm when you started it and the profit of prior years that you left in the firm. You should check to be sure that the rate of return on your investment is what it should be. You wouldn't leave money in a savings account without a reasonable return and your business is no different. Your trade association should be able to provide guidelines about the rate of return on investment in your line of business. Your accountant and banker are also sources of help.
YOUR TARGETED INCOME. After you know what you made last year, you can set a profit goal for next year. Be sure that your goal includes payment for your services and a return on your investment as noted above. Your goal should also include an amount for state and federal taxes. For example, if you want to make $10,000 after taxes, your goal before taxes should be about $13,333. You have to add this $3,333 to take care of state and federal taxes. Keep in mind that the larger your goal, the larger the amount that will have to be added to cover your taxes. Your accountant can help you determine the tax amount or give you a tax rate to use for budgeting purposes.
CAN YOU REACH YOUR GOAL?
The next step in preparing a budget is to determine whether you can achieve your profit goals. To do this, you must project your fixed costs and your variable costs. From these three figures -- targeted profit, fixed expenses, and variable expenses -- you can determine your required level of income. Many businesses start with a forecast of profits and work up to a forecast of sales. Even large corporations can determine the required return on investment that shareholders require, then work back to planned revenue goals. Alternatively, you can start with a sales forecast, but don't forget the bottom line must still give you the required return.
In gathering your figures, keep in mind that without accurate information budgeting becomes guessing. The owner-manager who has never budgeted should talk with an accountant about the process. Or, visit the Info Exchange and post your budget question under the appropriate discussion forum!
You may need to make some changes to your record keeping system to ensure that you are collecting enough information in the right format to assist with your budget. 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. A good place to start is with your Chart of Accounts. Consider each expense category listed and estimate the amount that you will spend for this category in the next year. Last year's income statement is a good reference point, but don't rely entirely on it -- consider changes in your markets, price changes, cost increases, etc., always going back to your business plan to make sure you are addressing all the goals and activities you've planned.
You will also need to approach fixed expenses a little differently than variable expenses.
FIXED EXPENSES. Regardless of sales, fixed expenses generally 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 EXPENSES. This type of expense varies with sales. In a product business, the cost of materials or goods for resale are the largest variable expenses. In some service businesses, the cost of labor is the biggest factor. Sales commissions, direct wages, payroll taxes, insurance, advertising, and delivery expense are other examples of variable expenses.
REVENUE. The next step in preparing your budget is to determine and evaluate your required revenues (sales). Step 1 is to calculate revenue from the figures you've already determined. Step 2 is to take a realistic look at the revenues you will have to generate in order to make your targeted profits. If you're a service business, what is the hourly rate you will have to charge and is it realistic? Will you need to increase your customer base? If so, is this increase achievable? If you manufacture and sell a product, are you able to make that many units with your current equipment? If the answers to these questions aren't favorable, then you need to go back and re-evaluate your plans.
Lucy's Beauty Shop illustrates the principles of budgeting in a small service and product sales business. This example also illustrates the concepts of fixed and variable expenses.
The owner-manager is Ms. Lucy Doe. The shop's income is from two sources: (1) from beauty services that are performed by three operators and (2) from cosmetics and perfumes that are sold by the receptionist. The receptionist also answers the telephone, keeps the shop's daily records, and prepares the checks for Ms. Doe to sign.
TARGETED INCOME. Ms. Doe decided that she wanted to increase her net profit after taxes. She set her target income at $10,000 for net profit after taxes. This figure meant that the shop's profit before taxes had to be about $13,333 because she figured that her taxes would amount to about 25% or $3,333.
This goal was an ambitious one because her previous year's net profit before taxes was $8,390 as shown below in Lucy's Beauty Shop - Profit and Loss Statement.
DETERMINING FIXED EXPENSES. As shown in the Profit and Loss Statement, Lucy determined that the shop's fixed expense items included: depreciation of equipment, receptionist's salary, insurance, rent, interest on a loan, and utilities (heat and air conditioning). In addition, about one half of the laundry and shop maintenance expense is fixed. In budgeting her fixed expenses for next year. Ms. Doe took into account: (1) the raise she intended to give the receptionist; (2) a change in amount of interest based on her new loan balance; and (3) a change in her insurance expense.
She estimated that her fixed expenses for next year would be $11,000.
DETERMINING VARIABLE EXPENSES. In Ms. Doe's beauty shop, the variable
expenses -- those that vary with sales -- are cost of cosmetics sold, shop supplies,
operator's salaries and taxes, utilities (water and electricity), about one-half of
laundry and shop maintenance. Operator's salaries are variable expenses in this example
because each operator receives one-half of the total price charged the customer -- their
salaries are based on business volume.
When determining variable expenses, Ms. Doe uses her trade journals for
information on budgeted percentages in addition to her business history. For budgeting
purposes, all costs are expressed as a percentage of the sales dollar to make the
calculations easier. In her case, the percentages are: beauty shop supplies 10%; laundry,
including uniforms 3%; water and variable utilities 1%; and payroll costs 5%.
Lucy estimates her total payroll costs at 5 percent of gross
revenue from service or 10 percent of salaries. Payroll taxes
both state and federal, account for 7.9 percent of the 10
percent, and payments for workers' compensation and other
employee insurance account for 2.1 percent.
DETERMINING EXPECTED SERVICE INCOME. The next step in
preparing a budget for Lucy's Beauty Shop is to determine the
expected service income contribution.
The basis for estimating this income for next year is the average
revenue for each operator's appointment with one customer. This
figure is $4.
One-half of the $4 belongs to the operator. Other variable
expenses take 76 cents. Thus, from each $4 unit of services that
is sold, $1.24 is left for service income contribution.
On this $630, the shop clears $390.60 calculated as follows:
The shop's cosmetic sales contribute a net revenue of 50 cents on the sales dollar. Mrs. Doe estimated, based on past experience, that she could sell another $2,000 of cosmetics without additional advertising (an increase of 17%).
COMPARING REVENUE AND COST. After Ms. Doe determines her variable expenses, fixed expenses, and the service income contribution, she is ready to test her budget. She does this by adding her total fixed expenses of $11,000 and the desired gross profit of $13,333. This total comes to $24,333.
But her initial budget shows that shop revenues will only be $21,061 as shown below. Thus, the store's revenues will not cover Ms. Doe's fixed expenses and desired profit. Resources will be about $3,300 short of the desired goal.
Because resources are not enough to cover fixed expenses and the desired profit, Ms.
Doe needs to consider adjusting her budget (and business plan) for the coming year. She
can go in at least three directions. One possibility is to add another operator. Another
is to try to increase cosmetic sales. A third solution is to reduce her expected profit.
In order to decide what to do, Ms. Doe needs answers to several questions about each
possibility. She may have to work up several tentative budgets to determine what to do.
Let's take a look at each alternative that Ms. Doe considered:
ADD ANOTHER OPERATOR. This possibility brings up a number of questions: Is there space for an additional booth? What additional fixed expenses will be incurred? Can another operator be kept busy? Is the relationship between fixed expenses and revenue in line with industry trends?
Ms. Doe considers each question and determines that:
INCREASE COSMETIC SALES. This possibility seems to be a logical way to increase income because each dollar of sales will increase the revenue by 50 cents. The first question is how much of an increase in cosmetic sales will be needed? Ms. Doe calculated that these sales must be increased by about 70 percent rather than by 17 percent as she originally planned. In order to reach her budget profit goal, she would need a additional revenues of $3,272 -- or approximately $6,500 more in product sales than in the first budget. This would require cosmetic sales of $20,500, which is an increase of 71% over last year!
Other questions to answer here are: Is this a realistic increase in product sales? By
what method will sales be increased? By reducing prices? What effect will these methods
have on revenue? How much additional inventory will be needed? How will it be financed? Is
storage and display space sufficient to accommodate increased sales? Will she have to add
new products that will require promotions? What advertising and selling costs would be
REDUCE EXPECTATIONS. Sometimes the only practical solution is to reduce the expected
profit. Ms. Doe decided that $10,000 net profit after taxes was not in the picture next
year. Based on her knowledge of the beauty shop business, she felt that her shop was not
quite ready to add another operator. For one thing, she foresaw the possibility of
personnel trouble if a new operator was not kept busy.
She also felt that trying to push cosmetic sales up so dramatically could cause
customer dissatisfaction. Her shop prides itself on having a relaxing environment without
high pressure sales. This alternative would require a change in that culture. She reminded
herself that customers regarded the shop's beauty service highly and decided that any
major growth in sales must come from that end of the business. Another operator and
$10,000 or more net profit after taxes might be feasible the year after next. Although she
would not make her profit goal (and her return on investment is below target), she
believes that another year of building a steady customer base will enable her to make her
target in the following year.
PERIODIC FEEDBACK AND CONTROL
A budget provides a tool for control. You start building this facility when your budget
for 12 months is completed. Break it down into quarters, or better yet into monthly
amounts. Such a breakdown allows you to check for any discrepancies that may not show up
readily in the annual figures. When many items are added together, it is easy for an error
to creep into the totals or for you to overlook items.
During the year, the monthly or quarterly budget provides you with one of the most important financial management tools. 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 comparison of your monthly or quarterly profit and loss statement shows whether or
not you are achieving your business plan goals. Set up a simple worksheet to compare
actual expenses to your budget and get in the practice of reviewing a) where all the money
goes, and b) any differences from the amounts you budgeted. Thus, you can 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 and help you navigate
the road to your business dream.
In this lesson we have covered the following points:
(Women's Economic Self-Sufficiency Team, Albuquerque, NM, 3/97.)