Why Create a Budget?
A well thought out budget serves two primary purposes:
- Creating a budget requires you to think about the future of your business.
- Does your revenue cover the cost of sales and the other costs of running your business
- What additional expenses will be required in the future that need to be met from operating cash flow
- What changes can you make to business operations to improve results
- Comparing actual results to the budget allows you to monitor the operation of your business.
- Are sales and cost of sales in line and progressing how you expected
- Are operating expenses in line or do you need to make business adjustments.
- If you implemented changes are the results tracking your estimates
- Problems can be identified early
Drafting the Budget
Create a Base Budget
Begin by reviewing last year’s information. Create a report showing income and expenses by month, by account. Download this to a spreadsheet. The first step will be to determine an average monthly income statement to be used as a basis for the next year budget. I like to create a spreadsheet column for a base monthly budget. This starts out as a simple average of the prior 12 months activity.
Review the revenue accounts and identify any seasonal fluctuation that you want to monitor. Determine if there are months that should be adjusted up or down for unusual circumstances. Your goal is to estimate an average monthly sales amount, by product if your books allow. Post this amount to the base budget column.
Next review the cost of sales accounts. Identify those expenses that vary based on sales and which are fixed. For expenses that vary based on sales volume calculate the cost of sales / sales revenue. The fraction or percent derived will be used to estimate variable cost of sales in the budget. This can be done by account or total. Multiply the percentage by the sales in the base budget column and enter the variable cost of sales. Average the fixed cost of sales for the period and enter in the base budget column.
The remaining expenses will be roughly fixed or variable. Fixed expenses should be identified, and the monthly average entered in the base budget. Review the variable expenses. An estimated amount can be entered in the base budget or the account can be left blank to identify the variable nature of the account. Generally, an amount is entered so that average net monthly income can be determined.
Modifying the base budget
The base monthly budget is a backwards looking estimate of income and expense items. To create a budget requires looking forward. Create a column for each month.
For each line item or account that is being budgeted determine what adjustments need made to the beginning number and post the adjusted amount into each period. As you complete the budget spreadsheet think about anticipated activity for the future and when it might occur. Consider:
- Are there seasonal variations in income or expense that should be taken into account?
- What increases or decreases in sales or expenses are expected.
- Will the change be a fixed amount, or will it grow over the year?
- Will certain activity levels create an additional level of expense to support the activity?
- If books are on a cash basis some expenses like bi-weekly payroll can vary significantly in certain months.
- Do you need to account for the number of days in a month?
- Should budget amounts be broken down by location or department?
- What unusual purchases are expected? Be sure to include those.
The income statement budget will not include certain cash expenses. Consider if you need a cash budget in addition to an income statement budget. Cash drawdowns that will not necessarily hit the income statement budget include:
- Increases in inventory
- Capital purchases
- Owner distributions
- Loan paydowns or draws
Finalize the Budget
As you complete the budget take time review the information as a whole. The focus on creating a budget tends to be very account level oriented. When completed make sure that the information makes sense given your prior year and expected future. The budget should reflect your goals and expectations for the future.
Using the Budget
The budget is used as a performance benchmark. Incorporate the budget into your accounting system and generate reports each month showing actual results compared to budgeted results. Analyzing the differences from budget should provide key information that can be used to guide improvement in your organization. Identify the key performance indicators for your business and pay special attention to them. If you identify activity and assumptions that do not match with your initial expectations, it is ok to change the future budget to match the new reality. Keeping the budget relevant will make it that much more useful.
I have created budgets spanning multiple business lines, departments and locations. Need help with yours, get in touch.