This guide helps you understand the importance of budgeting and how to create and use a budget effectively, so you can keep your business financially on track.
If you're thinking of starting a business, a budget shows you and your potential backers whether your idea is viable. Once your business is up and running, a budget provides a blueprint for your business' success, and an accurate measure of how it is performing against your blueprint, month by month.
Budgeting helps you forecast:
Building a detailed budget at the beginning of each year or financial period helps you make these forecasts more accurately. As each month ends, you can update your budget with actual data and adjust future estimates accordingly. This provides an accurate, at-a-glance projection of the business' financial position at the end of the budget period.
A detailed budget helps you:
Every new business starts with a zero-based budget - i.e. figures for sales, costs and profit based purely on estimates. The figures you use should reflect your business goals and ambitions.
If you know your marketplace, the figures should be an honest assessment of what you expect your business to achieve in the given budget period. If you have no experience in your marketplace, your first task should be to seek the guidance of someone who does. Their guidance and help will ensure your estimates are more realistic.
In future years you can produce historically based budgets, using sales, cost and profit data from past years as an accurate starting point to budget for the coming year.
To help you plan both for a great year and poor year, creating two budgets using best-case and worst-case figures can be helpful. Then you can think through the implications of each scenario and prepare accordingly.
Whether you decide to compile your budgets on paper or on a computer-based spreadsheet, the more accurate and up-to-date you make them - using all available data - the more useful they become. Regularly reviewing, updating and recalculating your budgets is an essential discipline, focusing your mind on costs, reminding you of business issues and giving you an accurate snapshot of how the company is performing against targets.
Even as you prepare to launch your business, you should be tweaking your budget as you gain more insight into production costs.
Annual budgeting is best done on a month-by-month basis, making sure you adjust monthly predictions if your business is likely to experience seasonal sales peaks during a year. For long-term financial planning, quarterly budgets are more useful.
For each product (or product group if you have lots), consider carefully the most accurate answers to these key questions:
Enter your results in a table like this:
Quarter 1 Total
Sales units (UA)
Selling price (PA)
Sales value (VA = UA x PA)
Sales units (UB)
Selling price (PB)
Sales value (VB = UB x PB)
Total sales value (VA + VB)
(Key: U = Units sold, P = Price per unit, V = Sales Value)
Using the simple formula sales units x sales price = sales value, you can calculate sales values for each month in a given period, adding them up to give you a quarterly figure (as in the illustration) and combine these to get yearly totals.
To make best use of your budget, plot your actual performance against it. You can then calculate how much over or under you are for your budget targets, identifying which products are over or under-performing. This is called a variance report.
If you have computerised accounting software, you should be able to input your monthly figures and the program will produce variance reports for you, both for that month and for the year to date. If not, you can construct your own report, like this one:
Year to date
Figures in brackets are negative.
The variance figure is produced by taking the budgeted figures away from the actual figures. The year-to-date figure is an accumulation of the amounts for each month.
By producing this variance report you can see several things clearly:
Why are these figures useful? The variance report gives you a snapshot of where your business stands financially compared to your budget. It also shows you in which months you have sold more than you thought you would and in which months you have sold less. By adding actual data you can easily spot trends. You can use this information to adjust future budgeted figures. This enables you to see - using all available data and having adjusted future budget figures - where the company will stand financially at the end of the budget period.
For instance, if you have an average positive variance of 10 per cent for the first six months of the year, it's reasonable to adjust your budgeted figures upwards for the rest of the year.
Your sales budget feeds into a profit and loss budget which, taking all your other costs into consideration, enables you to work out how much profit you make each month and how much you're likely to make in your budget period.
Cost of sales is a key part of working out how much profit you are making. Total revenue from sales minus total cost of sales equals profit.
First you need to work out how much it costs to produce the product, i.e. labour costs, materials etc. This is your unit cost. If you buy in your products, your unit cost is the wholesale price you pay for the product.
You then need to work out other costs per unit, i.e. every other cost involved in producing and selling each product. These include:
You need to work out what these costs are for each unit you sell. If the costs do not apply to individual units, such as utility bills and storage, take an average monthly cost and divide it by the number of units you think you will sell each month. This gives you an average estimated cost per unit for these costs. For instance: staff commission = £25p per unit; utility bills per month = £100 divided by an estimated 2000 units sold = 5p per unit; and so on.
If you take all of these costs and spread them over the months of the budget, you get total sales costs per month. From your sales budget use the predicted number of units per month and divide your sales costs by your number of sales. This gives you sales costs per unit. Add your unit cost to your sales cost per unit and you have your total cost of sale per unit.
To calculate your monthly cost of sales:
Other Costs of Sales
Cost of Sales
Total cost of sales
Gross profit is the surplus of money you've taken (turnover) once you've taken away your cost of sales. To calculate gross profit:
Less cost of sales
[G = T - C]
To find your real profit, you now need to deduct other costs not directly linked to sales and unit production. An example is rent, which won't vary however many units you sell. These are called fixed costs or overheads.
For your overheads, take into account all your other costs, including:
Remember, most overheads will change over time (due to inflation, for instance), although costs like office rent might be fixed for at least a year ahead. So when you're budgeting, it is important to include everything, be realistic and build in rising costs when you think they may occur. Most start-ups underestimate a lot of these overhead costs and end up with inaccurate profit estimates.
Note: if you are a manufacturer, be careful not to double-count items like labour costs and electricity that you have already built into your cost of sales.
Typically, to run a business you will need things like furniture, cars, computers, machine tools and so on. These are called capital items or fixed assets, and their purchase cost is not included in the budget. Instead, there is a special charge that accountants call depreciation. This is not an expense as such because it doesn't involve parting with any cash, but it does represent an estimate of the proportion of the value of your fixed assets that is used up during the year.
For example, if you buy a new machine every four years, and the last one cost you £1000, you should include a depreciation charge of 25% of this £1000, i.e. £250 in each of the four years. By doing so, you're building into your accounting surplus cash to buy new equipment when it is needed.
Let's extend our table with a few overhead items. Your list of items will probably be much longer, but this example is merely to illustrate the format.
Add up all the Overheads and deduct from your Gross Profit to give a Net Profit of £18,800 for the year.
% of sales
Sales value (turnover)
Professional fees - legal and accountancy
Take Table 5 and add two extra columns - one for actual figures and one for variance. The actual figures again come from your accounting records and again exclude VAT. And the variance is calculated as the difference between the actual and budget column figures.
Cost of sales
Note that if turnover or profit is less than budget, the variance is negative (i.e. in brackets). However, if costs or overheads are less than budget, the variance is positive.
Table 6 gives you a simplified overview. It clearly shows you where your budget varies compared to your actual figures. This enables you to pinpoint areas that need attention, or areas that are more cost-efficient for the company.
Just as important as your profitability is your cashflow. You can't sell things unless you buy or make them, both of which may involve paying out cash before getting any return from them. Most businesses that fail do so because they run out of available cash, often despite showing good profits. Cashflow problems can also arise in seasonal businesses or those with poor credit control.
So another vital table is a cashflow forecast, where you list all your cash inflows and outflows and when you expect them to occur. This highlights periods when you may need a temporary overdraft. If you have a detailed annual budget that shows cashflow issues in the short term but good profits at the end of the year, this will help obtaining finance.
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