Every year, in early spring, a collective sigh of relief and resolution marks the end of another stress-filled tax season for most business owners. You no sooner put down the champagne class at your New Year’s Eve party when you need to close the books on the calendar year, complete and reconcile your ledger entries, transfer all the facts and figures to your accountant/tax preparer, and sign and file your business and personal tax returns.
Whew! Thank goodness, that’s over, right? Well, before you file and/or box up all of the bits and pieces of paper that accounts for what your company did last year, consider analyzing your immediate past to secure your not-too-distant future. Now is the best time to create a corporate budget, one with some teeth in it.
Hey, I can appreciate the fact that you “laid out a budget” at the end of last year. So, if you have one, pull it out and take a gander at it. Oh, is this the first time this year you’ve had a chance to look at it? Do you catch my not-so-subtle point? A budget is not a smart budget until you make a habit of referring to it often—at least, a couple times weekly. There are many other things that distinguish smart budgeting . . . from just going through the motions of having a budget . . . from abandoning the practice altogether because it’s too burdensome and time-consuming.
This month’s installment offers helpful, easy-to-implement tips and techniques for creating a budget that could possibly propel your business to the next level; that’s assuming you’ve struggled with this challenging exercise in the past. If you think your company does a fairly decent job at budgeting, I hope you find these suggestions are exactly what you’ve been and should keep doing. Ready to take a trip to the mysterious land of Budgetville? Let’s go!
Budgeting builds capital
First, let’s understand what budgets do and don’t do. For a small business, a budget’s primary purpose is not to save money. It’s to build capital—capital that keeps a business solvent and creates wealth for its stakeholders. The money that flows through a company’s coffers can be classified and separated into revenues (income), assets (investments), fixed expenses (overhead) and discretionary spending (variable expenses). The basic premise of smart budgeting is to build capital—that is, maximize income and return on investments—and manage spending—a.k.a. control expenses.
There two types of budgeting mindsets from which a business can choose, depending on the prevailing market conditions at the time: 1) capital appreciation during a robust economy and 2) capital preservation during tough times. A smart budget allows a business owner the latitude to adjust on the fly, if need be.
To get started, a wise business owner should gather the company’s most recent—the last 24 months would be ideal, if they are available—financial statements. You are looking for the quarterly or annual Consolidated Income Statements (otherwise known as the Profit and Loss Statements), Balance Sheets and Cash Flow Statements. You will use the P & L Statement as a template for the smart budget—except your budget will have additional columns that will contain crucial and relevant information.
Let’s start with the last 12 months of the company’s fiscal history. For simplicity sake, let us assume the last 12 months were, coincidentally, calendar year 2007. The top line of most profit and loss statements usually reports gross revenue (sometimes called total income or gross sales). Revenues for a company may be divided into the types of income it collects or receives, but the line containing the gross revenue is one of the most important figures in the budgeting process of a business. Every other line of the consolidated income statement can—and should—be expressed as a percent of gross revenue.
Six steps of smart budgeting
As with any gourmet recipe, you begin by assembling your ingredients. Aside from the aforementioned financial statements, you will need a dash of common sense, a dollop of discipline and heaping servings of accountability and fortitude. If you follow the six steps to smart budgeting, you will have a living document from which to make many day-to-day business decisions.
Step one is learn from your past. Create a spreadsheet with columns for the 2007 year-end figures from the P & L statement—first for the entire year and then broken down by the 12 months or four quarters, if you can. Refine the line item for each row using the format of your profit and loss statement. Typically, you will find the order of line items from top to bottom will look something like this:
Income—Money coming into the business, often separated into sub-categories depending how many revenue streams the company enjoys. For example, if the business does screen printing, embroidery, signage and engraving, there may be a separate line item for each business division. Reimbursed expenses or other regular income, if that applies in your case, may be listed separately as well. The number of ways you define total revenue is strictly up to you and how much analysis you plan to do with the data.
Cost of goods sold—This section accounts for everything your company spends to produce or provide the products and services it sells. Common line items include raw materials, contracted work, materials that are consumed in the production process but do not end up in the finished goods (eg: anything that goes into making your screens), utilities for production (eg: electricity, gas), manufacturing labor, packaging, and delivery freight.
Fixed expenses—Also known as overhead, or general, selling and administrative (GS&A) costs. The line items that appear in this section include but are not limited to salaries and employee taxes, rent or property mortgage payments (assuming the business is not home-based), telephone, utilities for the building, insurance, general (office) supplies, business tax and license, dues and membership payments, lease payments for equipment, property tax and any other miscellaneous costs that must be paid regardless of how much the business sells. Again, the number of line items you decide to include here is totally up to your discretion.
Discretionary (or variable) expenses—These line items are costs a business incurs to support or promote the sale of its goods and services. Typically, one will find a line item for advertising, maintenance and repairs, operating supplies and services, postage and printing, professional fees (bank, legal, accounting), bad-debt allowances, entertainment, bonuses and commissions, travel expenses, housekeeping, charitable donations, temporary services and business taxes.
“The Bottom Line”—usually labeled Net Income.
By compiling and classifying all of what the company spent for all of last year, then each month, you are setting a reference point and defining the spending habits of the business. In the column immediately to the right of each dollar amount, insert a spreadsheet cell with the percent of total sales figure. For example, if the company brought in $1 million in gross revenues and spent $21,500 in advertising and promotion, that line item consumed 2.15 percent of sales. Now you have a basis to determine what you should budget for this year.
The second step of smart budgeting is judge your past. Ask yourself, if you had to do it again, what should you have done differently? Should you have invested more in sales-commission bonuses? Do you think you overdid the travel expenses? These shoulda-woulda-couldas become the goals you will set for your short-term (yearly) budget. Find the difference between what the ideal number for each line item should be and what it actually was. Any amount of money you could have saved becomes what the business can afford to invest going forward. Here is where smart budgeting differs from traditional budgeting methods. Remember, the primary purpose of budgeting is not to save money, but to build capital to re-invest in the enterprise.
Steps three and four are creating a short- and long-term budget, respectively. A short-term budget usually spans 12 months. For step three, take a look at each line item you’ve created in step one and use the guidance you gleaned from step two to complete 2008’s budget. Start with gross income and project what you would like see on that line of next year’s profit and loss statement. If growing your business 20 percent seems reasonable, multiply last year’s figure by 1.20 and start the budgeting process. Don’t just increase each line by 20 percent. Take the time to ask yourself if you need to spend 20 percent more on that line item in order to realize your business goals.
For your step four long-term budget, you will try to see a time when your net income line is 20 percent of total income. If in 2007, you were able to have a “bottom line” of 2.5 percent—or $21,500 from our $1 million example above—setting a goal of 20 percent net income is unrealistic for 2008, but it may be conceivable down the road, if you consider what a business can make and still make capital improvements in itself. Investments in the company are possible only with the money that can be saved line-item-by-line-item, and a healthy net income. Here’s where you look at the company’s Balance Sheet and find the fixed assets that will need replacing, upgrading or additional units. Certainly, twenty percent is a stretch goal, but if you don’t dream big, you won’t even win in the smallest measure.
What else must I do?
The last two steps are unique to smart budgeting as well. Step five is hold yourself accountable for keeping to the budget. Insert another column to the immediate right of the percent-of-sales cells. Label that column “Accountable Person.” Enter the person’s name that has the greatest influence over that line item, including gross revenues. If there is no name assigned to any line item, find one. If there are two or more names listed, narrow it down to only one. If the same name appears on too many lines and there are people in your company without line item responsibility, delegate down the organization. If you thought enough to create the line item, someone in your organization has to be held accountable to make the number happen. Each month, if any line item is off plan, that person must report to ownership two things: why it is off and what is the corrective action to bring it in line.
The final step will take all the fortitude the company can muster. Step six is if the budget blows up, take drastic measures. By blowing up, I mean you just can’t control your spending or forecasted sales are nowhere near what they need to be. If you fail to make budget four months in a row, it’s time to re-evaluate and re-tool your budget for the remainder of the year. Place a moratorium on certain discretionary line items until sales catch up with expenses. Be careful that you don’t cut or suspend line items that are “seeds” for future sales crops. Solicit professional help of a business coach or advisor to right the ship and get back on course.
I am confident that, if you try the recipe for smart budgeting and follow the steps in earnest, you will enjoy the fruits of the labor it takes to develop and execute it. Good luck!