Budgets are critical for all businesses. Whether your company is new or established, large or small, product or service–based, you need a budget to keep afloat. Essentially, budgets provide a roadmap for your business by setting the targets that the business strives to achieve.
Creating your budget also helps answer the question, “How much do we spend?” You need to know how much you have to spend on your growth, as well as identify the line where you begin spending too much. Aside from being your roadmap, budgets are typical requirements for many investors and board of directors.
While budgets are essential to your operation, they can be intimidating. Where do you start? How do you make a budget plan? What if the budget reveals bad news? If you’re having these thoughts, you’re not alone. These are common concerns that unfortunately often deter business owners from creating a formal budget. We’re here to let you know that creating a budget doesn’t have to be scary. Using the fundamentals we’ve put together, you can take it one step at a time and tackle your budget with ease:
The Budget Process
The main goal of creating a budget is to set revenue projections, cost of goods sold, gross profit margin targets and operating expenses. Once you outline this information, you can use it to make informed strategic and financial decisions.
Setting Revenue Goals
The stage of your business impacts the best way to set your revenue goals. For an established business with an operating history, look at past performance to determine if you think you can grow into the future. For a new business, start by researching your target market to establish a baseline.
When setting your revenue goals, keep in mind these key points:
Setting Fixed Costs
Fixed costs are those that must be paid and generally do not fluctuate with sales volumes, such as rent, utilities and insurance. This is a good place to start because your fixed costs are the most straightforward and consistent. Keep in mind that reducing your fixed costs can improve your cash flow but may require compromises. If you’re feeling like money is tight, you might reduce your fixed costs by renting a cheaper office space.
Setting Variable Costs
Variable costs are those that move with revenue and are necessary to earn revenue, such as employee labor for a services company, raw materials for a company making a product or the cost of goods sold for a retail company.
Looking to reduce your variable costs to better fit your budget? Try finding a less expensive supplier. Keep in mind that shifting variable costs is often less disruptive than shifting fixed costs. If you’re trying to increase your cash flow, we recommend looking at your variable costs first.
Setting Semi-Variable Costs
Semi-variable costs are those that can be variable with certain sales volume thresholds. Think employee salaries, advertising or marketing. There are several methods for sorting out your semi-variable costs:
- High-Low Method: This method helps you separate the fixed and variable components of your semi-variable costs by utilizing two sets of data based on your activity levels. One data point is the total semi-variable costs at your highest volume of activity, the other at your lowest volume of activity. Assuming that the fixed costs at both points are the same, you can separate the variable costs by looking at the difference between the two activity levels.
- Scatter Plot: For this method, you simply plot out points that represent your costs at different activity levels. You should see a pattern of increase or decrease in costs depending on your activity or number of units used. When you draw a line through your points, be sure to draw out the line to the y axis. Where you land on the y axis is your fixed cost and where your data points land are your variable costs based on activity levels.
- Regression Analysis: This is probably the easiest method to sort your semi-variable costs. Simply look at your bills and compare with your differing activity levels to calculate your fixed cost and variable cost. Using a software to track your costs and get insights can prove helpful in this process.
Using A Budget
Once you’ve set your budget, the most important thing is to measure your actual performance against the budget on a regular basis. We recommend doing this monthly. Measuring your budget against performance is critical to understanding if you are meeting, failing to meet or exceeding expectations, as well as determining your next steps.
If the actual performance is not aligning with the budget, you’ll need to investigate each area to identify the gaps. After extensive analysis, you can determine if your budget is truly misaligned with the company’s ability to perform in the future.
You can, and should, make adjustments to your budget as necessary. Just like your business, budgets are not static. As things change in your organization, your budget may need to be updated to stay accurate.
When making adjustments, there are two key areas that you should pay close attention to:
- Income: Analyze any shortfalls, turnovers and the timing of your income. These insights will help you better understand where you’re budgeting well (accurate projections for income, turnover, etc.) or where you can improve (i.e. high turnover that indicates your targets were maybe too low).
- Expenditure: Look at your current fixed, variable and semi-variable costs to see how they aligned with your original budget. Analyze the differences and make changes accordingly.
Here are some helpful tips for making adjustments:
- When making updates, analyze how a change in one line item may affect another.
- Ensure you have a reason. Don’t make adjustments simply because expenses were higher than expected or revenues were lower than expected.
Communicate with Shareholders
Share important aspects of your budget with key stakeholders in your organization—this is critical to ensure everyone’s priorities and expectations are aligned. Be sure to communicate how your budget impacts different areas of your company so that everyone can do their part to work within the budget. Set incentives to encourage everyone to stick to the budget.
Bottom line, to ensure your company is on (and stays on) the right track, you simply have to create a budget. Once you have your budget plan, there are a variety of budgeting tools and apps you can use to stay on track. You can also use your budget plan as a framework for more advanced budgeting and fundraising solutions.
If managing your budget seems difficult and you don’t have the time to measure these metrics consistently, it may be wise to enlist some help. ScaleFactor takes care of tedious bookkeeping tasks and offers solutions to help you budget and make better business decisions. Get expert advice and automate your accounting needs. Request a demo today!
Editor’s Note: This post was originally posted on February 16, 2016 and has been completely updated for accuracy and comprehensiveness.