What Is a Budget?
Although you might not know it, you prepare a budget each time you estimate how much cash you will have left at the end of the month after paying your bills.
A budget is a forecast of all cash sources and cash expenditures. It is organized in the same format as a financial statement, and most commonly covers a 12-month period. At the end of the year, the anticipated income and expenses developed in the budget are compared to the actual performance of the business as recorded in the financial statement.
Why Create a Budget?
A budget can greatly enhance your chances of success by helping you estimate future needs and plan profits, spending and overall cash flow. A budget allows you to perceive problems before they occur and alter your plans to prevent those problems.
This publication covers the basic concepts of budgeting and takes you through the step-by-step process of constructing a budget.
How to Use a Budget
In business, budgets help you determine how much money you have and how you will use it, and help you decide whether you have enough money to achieve your financial goals. As part of a business plan, a budget can help convince a loan officer that you know your business and have anticipated its needs.
A budget will indicate
- The cash required for necessary labor and/or materials
- Total start-up costs.
- Day-to-day maintenance costs.
- Revenues needed to support business operations.
- Expected profit.
If your budget indicates that you need more revenue than you can earn, adjust your plans by
- Reducing expenditures (e.g., hiring fewer employees, purchasing less expensive furniture, eliminating a telephone line).
- Expanding sales (e.g., selling additional products or services, conducting an aggressive marketing campaign).
- Lowering profit expectations (usually the least desirable option).
Every business should create a budget before investing money in new equipment or other assets and before signing leases. To ensure your goals can be reached, first put all the numbers down on paper so you can adjust and rework them as many times as necessary. Mistakes are far less costly when made on paper than with actual dollars.
Basic Budgeting Concepts
The three main elements of a budget are
- Sales revenue
- Total costs
Sales are the cornerstone of a budget. It is crucial to estimate anticipated sales as accurately as possible. Base estimates on actual past sales figures. Once you target sales, you can calculate the related expenses necessary to achieve your goals.
Total costs include fixed and variable costs. Estimating costs is complicated because you must identify which costs will change and by how much and which costs will remain unchanged. You also must consider inflation and rising prices when applicable.
Variable costs are those that vary directly with sales. One example is the purchase cost of inventory. The more inventory you sell, the higher your purchasing costs; the less you sell, the lower your purchasing costs. Similarly, freight and special packaging costs will vary directly with sales; these costs will not be incurred without a sale.
For example, a store owner pays 350,000 for supplies and sells them for 500,000. To calculate the cost of inventory purchases as a percentage of sales, the owner divides the amount paid by the amount received in sales (350,000 500,000 = 70 percent). This means 70 percent of sales will go to pay for the cost of inventory. If the store owner estimates 600,000 in sales for the next year, he or she should budget 70 percent of 600,000, or 420,000, for inventory purchases.
Fixed costs are those that do not change, regardless of sales volume. Rent is considered a fixed cost because it is totally independent of sales activity and, for the duration of the lease, will not change. For example, a five-year lease with an annual rent of $24,000 must be paid even if there are no sales. It doesn't matter whether sales are high or low; the rent is still $24,000.
Semivariable costs, such as salaries, wages and telephone expenses, have both variable and fixed components. For budgeting purposes, you may need to break semivariable costs into these two components. The fixed element represents the minimum cost of supplying a good or service. The variable element is that portion of the cost influenced by changes in activity. Examples of semivariable costs are the rental of delivery trucks and photocopying machines for a fixed cost per month plus a variable cost based on the volume of usage.
Inflation and Other Adjustments
A budget will be as good as the numbers used to make it. Therefore, it is important that your estimates and calculations be as accurate as possible.
Profit should be large enough to make a return on cash investment and a return on your work. Your investment is the money you put into the firm when you started it and the profit of prior years that you have left in the firm (retained earnings). If you can receive 10 percent interest on $25,000 by investing outside of your business, then you should expect a similar return when investing $25,000 in equipment and other assets within the business. When preparing your budget, add the expected return on investment to your targeted profits. Check with your trade association, accountant or banker to make sure that the rate of return on your investment is what it should be.
In targeting profits, you want to be sure you are receiving a fair return on your labor; your weekly paycheck should reflect what you could be earning elsewhere as an employee.
Basic Budget Equation
Sales = total cost + profit
This equation shows that every sales dollar you receive is made up partly of a recovery of your costs and partly of profit.
Another way to express the basic budgeting equation is
Sales - total cost = profit
This equation shows that after reimbursing yourself for the cost of producing the product or service, the remaining part of the sales dollar is profit. For example, if you expect $1,000 in sales income and you know that it costs 750 to produce, market and sell your product or service, your profit will be $250.
In calculating an operating budget, you will often make estimates based on past sales and cost figures. You will need to adjust these figures to reflect price increases, inflation and other changing factors.
The Budgeting Process
Before you can create a budget, you must answer three questions:
- How much net profit do you want the business to generate during the calendar year?
- How much will it cost to produce that profit?
- How much sales revenue is necessary to support both profit and costs?