First of all, do I need a budget?
In short, yes. A well-run household operates on a budget, even though it may not be written down. You are in business to make money – all the more reason to have a budget showing how you will do just that. A budget is an extension of your business plan and strategy, put into practice. It serves to quantify the plan in financial terms, and lends a sense of reality to conceptual ideas, transforming them into a feasible business endeavor. A well-prepared budget will serve as a baseline and an important reference point to guide your business in the right direction by providing an essential framework for the start-up and initial operating stages. In this sense, it is a very important tool in managing the business, provided the budget is based on realistic data that can be used to gauge actual performance.
Having a detailed budget will also be a distinct advantage when dealing with potential lenders and investors. It will give them a clear idea of what your business is about; how you intend to carry out the business plan, in concrete, financial terms; what the loan or investment is needed for; and how the money will be spent. A good budget will show a lender how the loan will be repaid, and will show an investor what type of return can be expected on the investment. In both cases, the budget will significantly improve your chances of getting the financing you need for the business. And if you have sufficient depth and detail built into your budget, it will be much more credible to lenders and investors.
Building blocks
Even though a budget is an estimate, or a projection of future events, it should be based as much as possible on actual data obtained by doing research, getting quotes, and assembling and organizing documentation and information. The idea behind building a budget from the bottom up is to start with what you know, or what you can find out. Starting at the bottom means going to the lowest level of detail, where you have building blocks – concrete pieces of information that can be put together to construct the various different line items such as revenues, cost of sales, advertising, rent, maintenance, utilities, and other overhead expenses. These building blocks are basically quantities, hours, prices and rates. Rather than budgeting total income and expenses as a certain amount per month, for example, you can break these figures down into their component parts.
Operating budget
The operating budget should be structured based on the way the business works. Revenues and expenses should be budgeted at the same level of detail as you are going to record it for actual operations. It provides you with a tool for managing your business. A sufficiently detailed budget will enable you to compare actual results with budgeted amounts and perform quantity and price variance analysis.
Product recipes for budgeting cost of sales
If your business involves selling a product, you may start by determining what it will take to make the product, regarding materials and supplies, labour, and overhead. If you can prepare a “recipe” for a product, and identify the ingredients, you can do some calculations based on quantities and prices to figure how much it will cost to make each unit of product. The elements include direct costs of raw materials, supplies, and labour.
If you want to determine an “all-in” cost, you will need to add in the indirect costs or overhead expenses, such as indirect labor (administrative and management, for example), utilities, maintenance, depreciation, insurance, and any other general expenses. Based on availability of time and materials, and your production capacity, you can determine how many units you are able to produce each month. If you know what your average monthly overhead expenses are, you can allocate the overhead over the number of units to determine how much should be added to the cost of each unit. If you are making more than one product, you may want to assign a weighting factor in allocating overhead expenses. For example, products with a higher direct cost would absorb more of the indirect costs.
Budgeting revenues
Products
One way to budget revenues is to take the budgeted cost of sales and add a profit margin. The unit cost of each product plus your expected profit margin would give you an estimated sales price. In this case, you should use the “all-in” value, to ensure that your selling price is sufficient to cover all your costs and still leave you with a margin. Budgeted revenue would then be the quantity of units times the estimated selling prices.
But there are market forces that you should also take into consideration, that may affect the price you can reasonably expect to charge to be competitive in the marketplace. In preparing the budget for revenue, you may want to collect information on competitors’ prices. Since you are most likely starting a business in which you already have knowledge and expertise, you may be well aware of these market factors. The critical aspect of budgeting is to try to quantify these aspects and incorporate them into budgeted selling prices, and estimated revenue.
If you are introducing a new product, you may be able to budget revenue based on prices for similar products, adding an incremental amount based on the expected added value of your product. If you have done a market study, this information will be valuable in building the budget.
Services
If you are in the service business, your inventory is your time. The building blocks for budgeting revenue in this case are the number of billable hours available, and the rate per hour. Hours and rates should be broken down by the person if the business involves different persons performing different functions.
Billable rates may vary, depending on the person’s qualifications and experience. And billable hours may vary depending on the person’s functions. A person dedicated almost entirely to customer service will have a different number of billable hours than a person who primarily performs administrative and support functions. You may factor the nonbillable hours into the billable hours, by incrementing the billing rate. Or the nonbillable hours may be left out and absorbed as overhead within the operating expenses.
Here again, you need to consider market dynamics. But you can reasonably estimate your revenue by determining your billable hours per month times the rate you expect to charge.
Jobs or projects
If your business involves jobs or projects, budgeting will probably include aspects of both product and service revenue budgeting. Based on your line of business, you will know what is involved in completing the job or project. The work may include materials and supplies, direct and indirect labour, use of equipment, and maybe subcontractors. Budgeting for tasks or projects may go hand-in-hand with submitting job estimates or bids. The terms and conditions of the work will play an essential role in how the work is quoted or budgeted. A lump sum contract for a particular job is different from a fixed rate contract, for instance.
Breaking down the job into its parts will be a crucial factor in submitting a good quote or bid, and budgeting job costs and revenues. You will want to make sure you have all your bases covered, in the sense that you include all your expenses, both direct and indirect, and allow yourself a sufficient margin. You may need to make out a materials list, a job schedule for direct labour, and an allocation calculation to include indirect expenses. If you are going to use subcontractors, you should get bids from them, hopefully before committing yourself to the job.
If your business involves jobs that extend over a more extended period, first you will want to make sure the amount you are charging for the job is sufficient to cover all your expenses and leave you with a margin that gives you an adequate monthly income during the period you are working on the job. You can budget monthly revenue and cost by spreading the total job over the months of work.
If you are working on several jobs at a time, you can use your timelines for each job, and then allocate the total revenues and costs for all the jobs over the applicable periods to come up a monthly budget.
Expenses
Expenses can also be broken down into components such as quantities, prices, and rates. Some costs are incurred as a function of usage, for example, materials and supplies. Other expenses are correlated with time periods, such as rent and insurance. The types of costs your business incurs will depend on your line of business, and the following are just some general examples of how you may be able to budget, by breaking down the expenses into their parts.
Employee compensation can be budgeted based on the hourly wages, or monthly or annual salary contracted with each person. You will need to plan for employer payroll taxes, which can be calculated using the applicable rates for Social Security, Medicare and unemployment taxes. You will also need to provide for any benefit plans you have agreed upon with your employees, such as health insurance, pension plans and others. If you have actual data on the cost of these plans, all the better. If not, you may want to budget based on a payroll burden, which is a percentage of employee base compensation.
You may have other employee-related expenses such as bonuses and awards, binds to completion of objectives or goals. It may be possible to correlate these expenses with a related item in the budget, such as sales.
If you plan to pay sales commissions to either your employees or outside salespersons, the budgeted commission’s expense will be a function of estimated sales. If you use an advertising agency, you should schedule based on the contractual terms. Advertising in telephone guides or on-line services can be planned based on their quoted rates, according to the type of ad you want to place.
You can budget the rent of property or equipment according to the monthly lease or rental amount. Insurance is generally prepaid, and you can do some accounting to spread the quoted insurance premium month-by-month over the policy period.
If you have a periodic preventive maintenance contract on equipment, you can budget based on the monthly cost of your contract. If you have purchased an extended warranty, you can spread the cost over the expected useful life of the related equipment or the duration of the deal. Repairs are generally an unforeseen expense and are more difficult to predict and budget, but you should not overlook them. You should probably estimate repair expenses based on your knowledge and experience, and based on the age and general working condition of your equipment and facilities.
Utilities, such as electricity and gas, can be calculated as usage times rate if you have an idea of how much you will use. You may be able to estimate usage based on a reference point, such as a similar business or facility, and multiply by the going rates in your area for electricity and gas.
Budgeted telephone expense is on the plan you have for your cell phone, for example. You can obtain the base monthly rate and installation cost for a new land-based line from your local telephone company. The expense for long-distance calls will depend on the nature of your business, and here you will have to estimate based on your judgement and personal experience.
If you use your vehicle in your business, you can estimate the average number of miles or kilometres you expect to drive each day or month. Then take this and multiply by the appropriate factor based on how many miles or kilometres your vehicle gets per gallon or litre, and the expected price of fuel. You may be able to budget travel expenses by estimating how many trips you plan to take to what places, and find out the going airfares and hotel rates.
You probably know what types of insurance coverage your business will need, and you may be able to get quotes on-line. Or you could go to an insurance agent and inquire.
Depreciation expense is on the cost or basis of your depreciable property and equipment, and the depreciation method you use. It may be straight-line depreciation over the useful life of your property. Or you may elect to use another way, such as the accelerated recovery system used for income tax purposes. Your budgeted depreciation should coincide with the depreciation method you intend to use for book purposes.
Finally, interest expense will depend on the loans your business carries. At the outset, you may not yet know what these will be since this will depend on the financing you can obtain. Your initial budget for interest expense could be on the amount of the funding you need, times the applicable interest rate for each particular type of financing. For example, financing with your credit card will generally carry a higher interest rate than a mortgage loan, secured by real property.
As mentioned above, these are just some examples and ideas, and you will need to adapt them to your particular circumstances. The important thing is to analyse your expenses and break them down into pieces of data that you can identify.
Start-up Requirements
Budgets are not all the same, and there is no standard format. Different types of budgets can be prepared for different purposes. One way to start, especially for a new business, is to prepare two separate budgets – one for start-up costs and capital expenditures, and another for the initial operating phase.
Organization Costs
Part of a small business’s start-up costs is organisation costs to get the company set up. Organization costs may include legal fees and expenses, notary fees, licenses and registrations, tax consulting and others. These costs will depend on the legal structure you select for your business and your line of business. For example, setting up a sole proprietorship will probably not involve significant legal costs, since it is not necessary to set up a separate legal entity. But legal fees may be more significant for a partnership, and even more so if the business is set up as a corporation. Attorneys should be able to estimate the cost of setting up a partnership or corporation.
If your business requires a commercial license or another type of operating permit, information about the cost should be available from the municipality or other legal jurisdiction in which the company will work.
Capital expenditures
In preparing a budget for capital expenditures, you may want to start by making a list of all the property, plant and equipment you will need to get the business started. These items could include real estate, machinery, equipment, vehicles, furniture, fixtures, and installations. Once you identify the things you need to acquire, you can start putting together cost information from catalogues, price lists, auctions, want ads, quotes, bids, offers, and appraisals. If the business involves building or remodelling a facility, a budget for the work could be prepared based on proposals for the job.
The documentation you collect in putting together a capital expenditures budget will serve as good, reliable support, and you may want to keep it along with your budget and business plan to present to potential lenders and investors, and for your reference purposes.