Budgeting allows business owners to weigh the costs and benefits before committing resources. It is also about making an educated guess as to how the future of your business’s finances will look. It requires examining what happened last month, three months ago, and what this month last year looked like, and using that information to make sound financial decisions for your business.
Usually, accountants take the previous year’s budget as a starting point to get a clear idea about how to increase revenue, cut costs, or both. Budgeting also differs from one business to another, for example, a service provider will not have the same budget as that of a construction company.
Also, start-up and established company won’t have the same budgets. However, all businesses take into account the economic, organisational and other variables that are not within the company’s control. So it understandable that in business, you have to account for both fixed an unexpected costs.
Why budgeting is important?
- Budgeting will save you from going down in flames some day.
- Without an efficient budgeting method, it’s difficult to manage your finances.
- Your budget evolves along with your business.
But before we can examine the importance of weekly, monthly or yearly budgets, let’s look at two approaches of managing budgets: top down and bottom up.
Top Down Budgeting:
In this approach, you take last year’s Profit and Loss add 5% to each line item and call it a budget. Some, slightly more nuanced version of this is how most companies do it. It keeps you on an even keel and you then dish out the budgets to your loyal employees, bestowing each the promise of autonomy and the threat of obliteration should they mess up.
Whether you are tight on administrative funds, or just frugal in general, this is the best bang for your buck.
- You are in control
- It is easy to evaluate
- Only one budget is created
- It is difficult to change even if it’s not working.
- The implementation cost is likely to be higher.
Bottom Up Budgeting:
With this approach, you have more time to go through each P+L line item and build up what you need from first principles. Put the “big rocks” for example, expenses such as salaries and rent, then slowly get quotes and estimates for other expenses as you go.
Your employees will help you along the way here and it is a great way to get buy-in from the entire team on how the business is run, giving them ownership of their particular line of items.
- More buy-in from your team
- Can drive you towards business objectives
- More time consuming as every department creates its own budget
- Staff are not incentivized to come up with small estimates
- Senior managers can set targets that are easy to achieve
Monthly, quarterly or yearly budget: explained
Usually, the budget numbers do not change, even if there are major market or operational changes. However, company’s needs can change every month, for example, when you decide to increase your marketing budget.
If your business is in an early stage or has inconsistent revenues, a monthly budget will be of more help in the short term than an annual budget. A monthly expense budget will help you ensure that you do not overspend.
For each reporting period, usually a month, you need to prepare a report (this should be easy if you are recording all your transactions accurately.) Then you will use the actual figures, the budgeted amounts, and the difference for both the current month and year to date to prepare a budget.
Usually, quarterly budgets often reflect how businesses compare their progress from year to year. The budget report from the first quarter of the current year gets compared to the report of the first quarter of the previous year to weigh progress.
Accountants can identify areas where the company has experienced financial issues from one year to the next, and then address those issues prior to the second quarter’s budget report coming out. A quarterly budget report can also be used to mark the progress of special projects such as capital investments or an ongoing sales contract to see how they’re affecting the business.
Annual Budget Reports
The main purpose of creating annual budget reports is to show how purchases done within a year affect your company’s bottom line. Additionally, a yearly budget can be used to gauge and compare the performance of the company from year to year.
A typical business planning cycle of a budget:
- 1. Review your current performance against last year/current year targets.
- 2. Work out your opportunities and threats.
- 3. Analyse your successes and failures during the previous year.
- 4. Look at your key objectives for the coming year and change or re-establish your longer-term planning.
- 5. Identify and refine the resource implications of your review and build a budget.
- 6. Define the new financial year’s profit-and-loss and balance-sheet targets.
- 7. Conclude the plan.
Essential components of a budget
It goes without saying that a budget will help you to forecast how much you expect to earn, plan where to spend that revenue and see the difference between your plan and reality.
However, a budget will only be a budget if it’s good, and it cannot unless it has the following components:
1. Your estimated revenue
This is the amount you expect to make from the sale of goods or services. It should be the first line on your budget. It can be based on last year’s numbers.
2. Your fixed costs
These are all your regular, consistent costs that don’t change according to how much you make, for example rent.
3. Your variable costs
These change according to production or sales volume, and are closely related to “costs of goods sold” A clear budget plan should outline what you expect to spend on all these costs.
4. Your one-off costs
One-off costs fall outside the usual work your business does. These could be startup costs like furniture, and software.
5. Your cash flow
This is all the cash flowing in and out of your business. It is said that you have a positive cash flow when there more cash flowing into your business than then there is cash flowing out of your business. It is calculated by subtracting the amount of money available at the beginning of a set period of time and at the end.
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