In my experience, when it comes to building a profitable and sustainable business, few things are more critical to success than developing and sticking to a budget. Think of it as a yardstick that helps you determine whether you’re:
- Achieving your overall financial goals
- Making the sales you hoped for
- Generating sufficient gross margin to not just cover your expenses but pay yourself a healthy wage
- Controlling your expenses
- Heading for any cash flow problems
Getting into the budgeting cycle
Budgeting is not something you can set and forget. It’s a set of tasks that you’ll almost always need to cycle through several times and revisit often. I’ve summarised the cycle, below.
1. Determine your sales forecast
Start by estimating what you’re going to generate in terms of sales. If your business is new, this can be very difficult to forecast, but if you have some sort of trading history you’ll be better positioned to build a realistic estimate.
Try to work from the ‘bottom up’ – in other words, rather than simply coming up with a dollar figure, estimate how many products or services you hope to sell, and at what price. I recommend using Excel and calculating a different figure for each month of the year rather than coming up with one lump sum.
2. Calculate your direct costs
Your direct costs are those that vary according to your sales. For example, for every widget you sell there’ll be a cost of having bought it. This is where the ‘bottom up’ approach helps, because if you know how many widgets you’ve forecast you’ll sell, and you know what it costs to buy them, you’ll be able to work out your direct costs (and the same is true if you‘re selling hours of labour).
The difference between your sales and your direct costs will tell you your budgeted gross profit (GP).
Armed with these figures you can start testing different assumptions, such as, “If I increase my sales volume by 10% (without changing my price) what happens to my gross margin?” Or, “What would happen if I increase my sales price by 10% and manage to maintain my sales volume?”
3. Factor in your expenses and outgoings
Your expenses are the things you spend money on that don’t vary with sales, such as your rent, marketing expenses and insurance. Some (such as rent and the wages of any staff) will be relatively fixed, while others (such as the amount you spend on advertising) can vary. You may also need to factor in outgoings such as the cost of your vehicle, tools or equipment.
In addition, if you’re selling products or offering credit to your customers, you’ll probably need cash (working capital) in order to cover these.
4. Review all the numbers and make some decisions
Now things start to get interesting! Hopefully your gross profit figure is larger than your expenses, because the difference between these two is your budgeted net profit.
Assuming your budget does indicate a profit, ask yourself whether it’s going to be enough for you to live on. If your budget is projecting a loss or not enough profit for your liking, cycle through the four steps of this process again, starting by reviewing all your assumptions. Can you increase your selling prices? Can you sell more in volume terms? Can you reduce the cost of buying your products (or labour) at a lower price? Can you reduce your expenses?
And if the answer to all of the above is “No”, the next questions to ask are, “Can I sustain a loss for some period of time until the business is generating a profit? And if so, for how long?”
If you work through your budget repeatedly and don’t arrive at a bottom line you can live with, don’t just keep going in the hope that things will miraculously work out okay. Instead, it’s time to revisit your business plan in its entirety and come up with a different approach. This is a critical point in your business planning – getting it right at this stage can save you many thousands of dollars.
Got any questions about these four simple steps to create your budget? Please ask them in the comments.