Creating a budget is like drawing a blueprint for your business’ financial success. Small business owners can use a comprehensive and realistic budget to help manage cash flow, control spending inside the organization, and project potential profitability. In this article, we’ll review how to create a budget and offer some budget optimization tips.
What is business budget planning?
Business budget planning is a process that begins with a cost and revenue analysis, but it doesn’t end there. Budgets can be used in conjunction with cash flow management to monitor and adjust spending, ensure cash flow needs are met, and ultimately make the company more profitable. Think of your budget as a living document. It may need regular updates.
Why should I create a business budget?
Without a budget, you’re flying blind. It’s like trying to pilot a boat on the open ocean without a navigation system. Budgets set spending parameters that are based on realistic revenue projections. They take the financial guesswork out of running your business. No one likes to be surprised by expenses that should have been anticipated––that’s what budgets are for.
How to create a business budget
There are several steps to creating a business budget, which break down into three basic categories. Analyze first, predict based on that analysis, then adjust for future periods. Your budget committee should also do regular reviews to make sure the current budget is working. Here’s what all that looks like when broken down into individual steps:
1. Select a prior reporting period
Choose a prior reporting period to act as a baseline for creating your new budget. This can be the previous month, quarter, or year. Monthly budgets are best if you’re just starting out.
2. Add up revenue from all sources
Review your revenue numbers from the previous reporting period. Add up sales revenue, interest income, and regular payments made to your company. Do not include one-off revenue like equipment sales because they won’t repeat in the upcoming reporting period.
3. Add up expenses
Add up all expenses and costs, both fixed and variable, to come up with a number for total cash outflows in the previous reporting period.
4. Calculate a baseline profit margin
Subtract total expenses from total revenue to get your baseline profit margin. To view it as a percentage, divide it into the total revenue number. Your goal in the next few steps is to find ways to increase that margin.
5. Estimate future cash flows
Review revenue from the last period to see what’s likely to repeat. Add up accounts receivable that are due before the end of the period to see if that number matches. Realistically project cash flows for the period.
6. Analyze and negotiate fixed costs
Many fixed costs can be negotiated down. Examples of this are rents, vendor contracts, and interest rates on debt. Reduce costs where you can, then add up all fixed costs for the new period.
7. Review variable costs
Variable costs are different from fixed costs. Many of them go up or down based on revenue. If you’re using a spreadsheet to create your budget, you should calculate this entry as a percentage of revenue, not a fixed number.
8. Set spending parameters
Itemize costs into subgroups like sales, admin, and inventory. Set spending limits for each group. These parameters will give those departments guidelines on what they can spend and how they can spend it.
9. Calculate projected profit margin
Use the new numbers from the previous three steps to project a profit margin for the new reporting period. Is it higher than the previous period? If not, ask why. There are several good reasons to increase a budget. Just make sure it’s clear why you chose to increase spending.
10. Schedule a review
Don’t wait until the end of the reporting period to do a review. Spot check it during the month to make sure the budget doesn’t go too far off track. Schedule a full review when you sit down to create next month’s budget.
Budget optimization tips
There’s nothing wrong with using a basic spreadsheet to create a budget, but more sophisticated expense management tools can help optimize it. Another tip is to leave some margin for error. Costs may increase, revenue might be lower than projected, and unexpected expenses can derail a budget if you don’t leave yourself a financial cushion for them.
Using your budget to help cash flow management
We mentioned at the top of this article how you can use a budget in conjunction with cash flow management to increase profitability. One way to do this is to set up sub-accounts to track spending by department or spending category. This system can also be used for special projects where a separate budget is created for the project manager.
Discuss sub-accounts with your accounting department before implementing them to make sure they match up with the T-accounts in the general ledger. If done properly, this system can help simplify tax filings and financial reporting, particularly your cash flow statement.
