Based on your forecasts, Budgets are your primary tool to shape the future of your business by laying out a series of reasonable yet challenging financial targets.
In the following, we'll cover the two most common types of budgets.
- Budgeted Income Statement
- Cash Budget
Budgeted Income Statement
As the name implies, your Budgeted Income Statement is a projection of your current Income Statement into the future. This is the “traditional” budget that most people think of when they think about budgets. In fact, if you currently have a budget for your business it is probably a Budgeted Income Statement.
Building on your forecasts, set a budget that is realistic yet challenging. A budget should not simply predict the future; a budget should encourage you to stretch a little. Certainly, you must be realistic, but a budget that presents no challenge holds significantly less value than one that encourages you to grow.
Your first concern when designing your budget should be future sales. Your projections are only as good as your sales forecast because almost everything in your budget revolves around this number.
One way to forecast sales is to base them on expected or desired profits. In this case, you begin with the profit you plan to make during a specific accounting period, add your Fixed Expenses for that period and divide by your Target Contribution Margin. Of course you will then need to determine if your Sales Targets are feasible, but at least it will give you a place to start. As your ability to accurately predict and achieve Sales targets is fundamental to the success of your business, build a system designed specifically for this role.
Net Sales Target = (Operating Profit Goal + Fixed Expenses) ÷ Contribution Margin
Example: January = (16,100 + 16,100) ÷ 0.4 = $80,500
Once you have determined your Sales Target, go through the rest of your budget, line by line, to determine your targets for each of the accounts on your Income Statement.
Create a 12-month budget for your business.
Your Cash Forecast is a projection of your Cash Flow Statements into the future. It lets you know when you can expect to be short on cash and when you can expect to have cash available for reinvesting in your business, or some other purpose. Your Cash Budget takes into account your Cash Forecast, but is more than a passive look ahead at what to expect, it is a goal to strive for. Your Cash Budget should push your business to do better than your Cash Forecast. When you are aware of an upcoming shortage of cash, you can plan for it by conserving cash when it's more readily available. When you know that you will have excess cash for a period of time, you can plan to invest it or use it to grow your business.
Writing a budget is one thing, using it is another. Make sure you pick a recurring date (i.e. every time you review your financial statements) to review your budgets and your progress toward them.
Produce a cash budget for your business.
Budget Variance Reports
To monitor your financial progress, you must regularly compare your budgeted figures with your actual figures. You need to be aware of any significant differences between where you actually are and where you intended to be. A Budget Variance Report tracks these variations, allowing you to react to problems before they go too far. Essentially, they are your Income and Cash-flow statements combined with your Budgeting information.
Budgeted Income Statement Variance Reports
These are often referred to as simply Budget Variance Reports, because they are the most common ones produced. To develop one for your business, take out your most recent Income Statement, along with your Budgeted Income Statement. Next, match your budgeted numbers to your actual numbers, by listing them next to each other. Finally, calculate the difference between the two numbers and list this information as well.
Divide your Income Statement (Actual) numbers by your Budgeted numbers, and multiply by 100 to calculate your variance percentage.
Complete a Budget Variance Report from your Income Statement.
Cash Budget Variance Reports
You can create a Variance Report for your Cash Budget in much the same way. Comparing your expected cash flow with your actual cash flow will allow you to better prepare for your future. Keep in mind that your budget is a goal that should stretch you a little further than your forecast. Your forecast is a passive look ahead based on past and current information,; your budget is a goal that you will need to perform well to succeed.
Complete a Budget Variance Report for your Cash Budget.
Because they are essentially Cash Flow Statements combined with Budget information, you may wish to replace your Cash Flow Statements with your Cash Budgeted Variance Reports.
One of the problems with the traditional budgeting process is that it's finite. It has a beginning and an end. Most businesses write a budget for one year and at the end of that year, they write another one. The budget begins and ends, then a new budget begins and ends, and so on.
Not only does the preparation of each new budget create an annual workload, but it also encourages you to look 12 full months into your financial future only once a year. In month two, for example, your budget shrinks to 11 months, in month three it shrinks to 10 months, and so forth. In fact, at the end of your 12th month, you aren't looking into your financial future at all. This creates a huge disadvantage when it comes to strategic planning.
Create a Budgeting System.
The solution to this problem is a perpetual budgeting process called a Rolling Budget (or Continuous Budget). This is the process of adding onto the end of your existing budget every three months or so. This way, your budget is kept up to date, forcing you to regularly look 12 months into your financial future.