If you’re running a business and you don’t have a budget, it’s like driving a car with no dashboard. You have no idea what speed you’re going; you’re guessing based on the cars around you. How much gas does the car have, or how far can you drive before you need to fill up? You have no other warning lights to help you gauge your car’s health or identify where things need to be tuned up or fixed. If you run your business like a car without a dashboard, it’s likely to die on the road at some point.
For business owners and leaders, budgeting is a key resource to make informed decisions. It guides your goals and performance. Yet, according to a Clutch survey, only half of small businesses created an official budget in 2020. I know this statistic remains true to this day, based on my clients and small business owners I speak to. It is one of the top services we offer at Welhouse Consulting.
Budget Excuses
Creating a budget can seem overwhelming and intimidating to those who often claim they are not accounting gurus. Most small businesses are started because someone has a passion for something like crafting, cooking, interior design, woodworking/carpentry, or health/wellness. They leave corporate America for freedom from bureaucracies, policies, and office politics. Some just believe they can do it better their way. The problem, according to Forbes, is that nearly 90% of startups fail because they create products nobody wants, while over 80% struggle with cash flow management and undercapitalization.
Notice that two of the three reasons businesses fail are financially related. Cash flow and undercapitalization can both be seen through the budgeting process and using your budget as a dashboard. But when you ask these small business owners why they don’t budget, you hear statements like:
- Don’t have time to waste on pushing paper; we have a business to run.
- It’s not necessary because we are small, and I know where every dollar is.
- As soon as anyone budgets, it is obsolete because the world and business are changing every second.
- I am not limiting my potential to a budget; I am growing as fast as I can.
- A budget? That’s corporate speak and exactly why I left.
These are excuses for fear of facing the unknown of how to budget and then hold oneself and others accountable to it. However, budgeting increases your odds of not failing because it’s like a car dashboard: it tells you what is going on with the business.
Why Budget?
A budget is the main dashboard of your business. It is where planning for the upcoming year becomes real because money is needed to succeed. Creating an annual budget allows you to evaluate your business by taking a deep dive into what is financially working, what is not, and what you plan to do to correct it. It moves you from thinking you understand your numbers to actually seeing and knowing them, so you can plan for success rather than hope for it.
What’s costing you?
As a business, do you know what your greatest expenses are and how much they have increased in the past three years? The number one thing I see in creating budgets for clients is overpaying for things over time. When you don’t monitor and plan for expenses, they tend to keep growing. Many business owners will try to solve problems by spending more money. We need more people, more tools, better computers, or more software. They will invest in these things, not evaluating what they have, thinking the investment will bring efficiencies and revenue. Instead, they are unplanned expenses that can lead to financial distress.
Dump bucket accounts like ‘software and subscriptions’ become a main culprit of cost accumulation. Businesses keep adding more software items or licenses that auto-renew, often with price increases. When you review category spending to create a budget, you can take a moment to understand what’s in the account, assess its need, and decide what to do with it. You start to see your business in a very different way, allowing you to improve your bottom line for the upcoming year and the long term.
Are You Charging Enough?
Although having a dashboard for your business is critically important, the main reason to budget is to understand what your markup or margin needs to be to ensure you actually make a profit. Many businesses rely on industry averages or competitors’ practices, and it doesn’t work. Not knowing your business’s expenses and setting a selling price that covers them and makes you a profit is operating without a dashboard. Your business will be on the side of the road very soon, out of money.
Relying on industry averages or what you hear your competitors are doing in terms of markup or margin is like trying to gauge your speed by how fast or slow the cars around you are driving. You don’t know their COGS or expenses compared to yours. If they have office space and you work from home, you have fewer expenses. To properly set your selling price, you need to know your business’s numbers, so you actually make a profit and don’t gouge customers.
Unify the Team
Having an open-book management approach with your staff helps everyone work towards the same goal. Everyone’s understanding of the business’s finances gives them insight into what they do every day and how that impacts the bottom line. Participating in the budget process allows employees to be involved in the business’s overall plan and take ownership of actions and decisions in the company’s best interests. Financial success is an activity everyone participates in.
Actuals vs Budget
Comparing your actual profit and loss (P&L) statement to your budget on a minimum monthly basis provides information on how you are performing. Just note that the P&L data is a lag measure, or an after-the-fact measure. Regardless, it provides insight into your finances and helps you forecast, using other business data, for how quickly you need to address financial matters. Meaning, if you are losing money, do you know why? Are you overspending, lacking in sales, or both? Comparing your actuals versus budget will show you exactly what is happening and what to address. Are you making more money than you budgeted for? A fabulous problem to have, but it can still be a problem if you don’t adjust your quarterly tax payments or plan accordingly for year-end taxes. The point is that budgets ease the process of monitoring finances and making decisions throughout the year.
Budget Components
A budget is a financial plan or estimate for your company. It is a projection for the fiscal year forecasting income and expenses. A budget has three main components.
Income
At the top is the income. This is also known as total revenue, sales, or volume. It is the amount of money your company is planning to bring in for the year through the sale of your products and services. Revenue indicates the company’s financial size, but not its success. Success is determined by profit, not income.
Cost of Goods Sold
Next is the Cost of Goods Sold (COGS). Not every business has COGS. Service-based businesses, such as most non-profits, consultants, financial advisors, legal services, personal trainers, or any business that does not manufacture, sell products, or hold inventory, will not have COGS.
If you have COGS, this is also known as direct expense or job costs. In other words, all expenses that are directly related to the job, product produced, or items purchased for resale. Examples include raw materials, labor to produce the goods, shipping, and work by trade partners, such as an electrician, as well as products you buy and resell. These are also known as variable costs because they vary – increase or decrease – according to the level of business activity. The more revenue you bring in, the more direct costs you will have.
Expense
Last is your business expenses, also known as indirect costs, operating expense, or overhead. In other words, it is all the expenses related to operating your business. Examples would be rent, telephone, insurance, office equipment, and labor to operate the business. These are mostly fixed costs because they are independent of revenue and will occur regardless of sales. You typically know what they are and how much they will be.
Educated Guess
You don’t need to be an accounting genius to create a budget. The budget is a forecast or an educated guess of how you expect your business to perform for the coming year. It’s an educated guess because you use known intelligence to create a projection. There are five categories of information that a budget is based on.
Historical Data
Historical data is the information inside your accounting software about how your company has performed in the past. Ideally, use 3 years of actual profit-and-loss statements to see year-over-year trends. If you don’t have three years, use what you do have. Put the data in a spreadsheet side by side, and you will quickly see what is happening in your business. Are income, COGS, and expense accounts going up, down, or steady? Calculate your performance per year:
- Percent of total COGS = COGS / Income
- Gross Profit (margin) = Gross profit (Income – COGS) / Income
- Percent of Total Expense = Expense / Income
- Percent of Total Labor = All labor expense (fully loaded) / Income
- Net Profit Percent = Net Profit (Gross Profit – Expense) / Income
How do your numbers look? Do you need to reduce COGS for more gross profit? Is labor too high for your income? Are you making a profit and enough to consider yourself a business versus a hobby? All this data will guide you on how the business needs to perform to be successful in the coming year.
Actual Data
This is all the information you know about or can easily obtain for your business for the coming year. Most, but not all, is related to fixed costs. How much will your rent or mortgage be? Vehicle payments? Cellphone bills? Insurance? Software? What are your labor costs, and are you planning any merit increases? Do you have contracts for expenses or COGS that specify the amounts? What price increases are being passed on to you or the upcoming year? All of these numbers are actual and can be included in your budget for the upcoming year.
Strategy
If you have a strategy and are creating annual plans, what is the work plan for the upcoming year? Are you making any improvements, creating new products or services that require funding? Are there planned capital expenses? Do you intend to grow in a way that will increase COGS or other expenses? Are you adding more labor? Are you having a price increase to generate more revenue? Signed on new customers? How will all of this information change the historical and the actual data going forward? Do you need to get revised quotes or pricing to accommodate the plan?
Economy
What are the economic conditions or projections for the upcoming year? What is happening to inflation? Interest rates? How is the overall economic growth (GDP)? Where is consumer confidence and spending trending? Is your supply chain being impacted by material shortages, natural disasters, gas prices, tariffs, or wars? Are there any tax policy changes that impact your business? Some businesses see a slowdown in Presidential election years. The point is what is happening in the world around your business, on the local, state, or national level, now or in the coming year, that could have a financial impact, and how can you plan for this while budgeting?
Competitive Landscape
Knowing your industry, competitors, and their pricing also helps you gauge your business performance. If your COGS and expenses are too high for your size, number of people, and revenue, you could be overcharging, making you less competitive in the marketplace. Understanding your market and competitor pricing tells you if you are leaving money on the table or losing business because you are overpriced.
Industry data provides benchmarks for margins, markups, growth, labor percentages, profit percentages, and more. There are good gauges to use to know where your business stands against the industry, but they should not be used as your numbers. These are tools to tell you where your business may be out of bounds and needs attention to be competitive.
The Budget
Putting all this knowledge and assumptions into a spreadsheet against your chart of accounts creates your budget. Calculate specifically your COGS percentage, gross profit, and net profit.
- Percent of total COGS = COGS / Income
- Gross Profit (margin) = Gross profit (Income – COGS) / Income
- Net Profit Percent = Net Profit (Gross Profit – Expense) / Income
How do the numbers look? Go back and adjust using known intelligence until you hit the goal or desired numbers. That doesn’t mean cutting expenses you know will incur or arbitrarily adding to your income to balance your numbers without a plan. If your numbers are really off, it means going back to the team and making tough decisions to fix it. Do you delay hiring or cut staff, put off buying a new piece of equipment, or expand your marketplace to generate more income? Tough decisions today, ensuring you make the proper profit, will yield a long-term business you can grow over time.
Budget for Profit
PNC Bank defines profit as the final profit figure after all expenses, including taxes and interest, are deducted. This includes your salary as the owner as well. Often, small businesses do not include a true owner’s salary and instead claim the profit as their salary. Profits are above and beyond the owner’s salary. The owner’s salary is an expense. Profit in a for-profit business is intended to be shared with employees or other stakeholders. In all businesses, for-profit and nonprofit, profit is reinvested in reserves, capital, and human resources to continue evolving and growing the business. That means you need to budget for the desired profit percentage you want out of your business for maintenance and growth. Not doing so means you have a hobby, not a business.
Reserves
Often, small businesses and non-profits do not understand the concept of a reserve. Some people call it a rainy-day fund. No, it’s a serious, deliberate saving of money for an emergency. It’s not rain, it’s a hurricane. The Proceedings of the National Academy of Sciences (PNAS) research stated that financial fragility caused 41% of small businesses to permanently close during the first year of the COVID-19 pandemic. Why? Because they didn’t have the financial reserves to sustain their business, meaning pay fixed costs, when there was no income. Businesses should strive to have at least 6 months of operating expenses in reserves. I would recommend striving for a full year. It’s not a matter of if something like COVID-19 hits again, but when. Can your business sustain and recover from a three or six-month shutdown?
Further, if you intend to sustain and grow your business, you need money to reinvest in capital and human expenditures. Allocating a percentage of profit to these future expenses helps make them a reality. If your strategy calls for a new employee, having at least six months of their salary saved allows the business to hire, onboard, and get the person performing without stressing the budget.
Final Notes
Creating a budget will enable you to scale your business and improve long-term planning. You will have a process in place, know your margin for your sale price, and a dashboard to monitor your business’s performance year over year and month over month. In building your budget, err on the conservative side: overestimate your expenses and underestimate your revenues while still making a profit. Ultimately, you want some flexibility for unplanned expenses because they will happen. Your focus is on making a profit to share with stakeholders and saving for reserves, capital, and human expenses to reinvest in your business.
Although you can use Artificial Intelligence (AI) today to analyze your historical data and draft a budget, I recommend you wait until you really understand your business’s numbers. Yes, AI can give you answers, but what are you really learning? The more you really understand your business, basic financial numbers, and the impact of financial decisions, the better you will run your business. Get a basic understanding of your dashboard and then let AI supplement your analysis.
