Fundamentals of Business
It is budget season!
A budget provides a map for the road ahead, and every business needs one. A business can use a budget to plan for revenue, expenses, staffing levels, cash flow and financing needs, making long-term investments (capital expenditures), and expansion of the business.
Now is time of year to do this. It may be hard to predict 2021 with what we have seen in 2020, but that makes it all the more important to plan the future direction of your company… and maybe even add a couple of alternate scenarios just in case.
Step 1: Create a budget
Most small businesses can use Microsoft Excel to create an effective budget. Larger businesses can invest in software designed for building budgets, but this can cost up to several thousand dollars not including the staff time needed to develop the budget.
Attention to detail is critically important here. Skipping steps or taking shortcuts will result in a budget that adds little value to decision making. Invest the time in being as precise as possible. A company’s recent history can be an excellent guide for getting started.
Here are two budget line-item examples.
- Revenue: This is the per unit price multiplied by the volume of units for the product or service. Break this down by day, week, or month. Adjust for seasonality if needed. This may also need to be split by each SKU (stock keeping unit). Every business is different, and you will need to determine what provides you with the best information.
- Payroll: This is the salary or hourly rate multiplied by the number of weeks or hours. Then add in the company’s portion of taxes for federal and state, fringe benefits such as health insurance, retirement contributions, etc.
Once an initial draft is completed, discuss the results with other senior managers to get input and to challenge assumptions. The most common mistake is to substantially increase sales or reduce costs without a specific action plan to accomplish those results. So be sure to create an action plan that aligns with the budget. This would include actions such as increasing sales calls, adding new products, or downsizing staff. A final version of the budget should be approved by the business owner(s) or Board of Directors.
Step 2: Measure the company’s performance
I have a long-time client who likes to say, “You are what you measure”. He is correct. Failing to measure performance will leave the company blind to what is happening until it is too late.
I recommend looking at four categories for budget variances: Cash, Revenue, Expense, and Profit/(Loss). This will give a high-level snapshot of the business. Within these categories, the following are some examples to drill down and measure performance:
- Price and volume (unit) variances: Why are revenues higher or lower than budget? Are prices changing or did the business sell more/less units? It is possible to calculate the impact of price and volume variances to see what happened. Revenue variances are typically a combination of the two, but one of them could be the dominating reason.
- Labor and material variances: What are the primary expenses and are they over/under budget? Are labor or material costs too high? Was there unexpected staff turnover? This is an opportunity to control expenses and resources.
Budgets can also be used to set employee goals and provide accountability. They can communicate the company’s plans which help to get the entire team on the same page. Take advantage of these added benefits by being transparent and sharing as much as possible with staff except for confidential payroll information, as necessary.
One note of caution: Budgets are not set in stone, but do not create a new budget just because there are large variances. It will be tempting to create a new budget when the variances are unfavorable and impacting employee performance reviews, but you must resist. Keeping the budget allows you to evaluate the original assumptions and estimates. Creating a new budget mid-year should be reserved for only the most significant changes to a business. The 2020 pandemic would certainly be an example of when it is better to create a new budget than to try to measure against an irrelevant budget.
Step 3: Make decisions
What decisions should you make based on the measured variances?
Here are some examples:
- Going back to the price and volume variances, suppose the company raised prices but did not see an offsetting decrease in units sold such that revenue was still beating budget. This would indicate that the company has some pricing power with customers, and the company may want to continue increasing prices in the future.
- What if the cost of materials is over budget due to higher costs from suppliers? The company should evaluate the total cost of its products and whether it should increase retail prices to the customers to make up for the increased production costs. The company could also consider switching to a less expensive vendor with acceptable quality if it does not think customers can absorb higher retail prices.
Take advantage and use whatever information your budget and financial statements tell you about the business. Typically, it is necessary to make some course corrections throughout the year.
In the end, all businesses need a budget. A best practice is for a business to create a budget every year and then have the discipline to stick with the process. Taking the time to plan is a valuable investment in a company’s future, and it will provide information to adapt and make changes along the way.
Spectrum Small Business Advisors is here to help. Contact James Gargiulo at (949) 351-1538 or James@SpectrumSBA.com for assistance with your business.