Small Business Budgeting 101: Boosting The Financial Health of Your Business

Keep it Simple and Take the First Step

Budgeting is a common term in personal finance, but did you know it’s a critical component in maintaining your business’s financial health too? The right budget aligns your actions and goals, helping you reach important milestones, such as a sales threshold or planning for a path that leads to a successful business sale.

As you read through this article, we encourage you to take the first steps toward budgeting, no matter how simple the exercise might seem. Although business budgeting can be daunting to those who haven’t attempted it, taking small steps towards a financial plan can have big benefits, including greater profitability, higher levels of operating efficiency, and identifying opportunities for growth.

Budget Basics and the Benefit For Your Team

The goal of a budget is to produce an operating plan that conveys management’s intent for implementing the business’s strategy. For example, if management desires to grow sales by 5% in the upcoming period, the budget will outline how many units and at what price the business should sell those units to realize the goal. Units can be physical products, such as apparel, or services, such as pet grooming.

Budgets are based on the three main financial statements: the income statement, balance sheet, and cash flow statement. Most budgeting methods will use historical information as a baseline and adjust expectations based on one-time items, market conditions, and strategic goals.

A Roadmap For You and Your Managers

The information found within a budget is crucial for providing managers and team members with a roadmap of operations. For example, an overall budget for the next month or quarter can be used to establish granular department level budgets for sales, administrative, product, or research functions.

Separating Fixed and Variable Expenses

Expenses can either be fixed or variable. A fixed expense is a static cost that doesn’t change based on actual activity levels, while a variable expense fluctuates based on activity levels. For instance, a pet grooming business has a fixed rent expense that doesn’t fluctuate month-to-month, regardless of how frequently the space is utilized to generate revenue. On the other hand, the pet grooming business would incur variable costs for shampoo or other products that are consumed when the grooming service is delivered.

Three Budgeting Methods We Recommend

There are several budgeting approaches available to businesses. Some are quite complex and time consuming, and don’t enhance accuracy to an extent that warrants the investment of time and effort, especially for small businesses. Below are three methods we recommend for owners just beginning the budgeting process, or for those who are seasoned financial planners. Remember, the best budgeting approach is the one you’re comfortable with, and that helps you realize your operating goals.

1. Extrapolation Budgeting  Extrapolation budgeting takes prior year performance and builds out expectations based on headcount, revenue trends, industry trends, and other factors. For example, if the prior year showed $1,000,000 in gross sales and management is expecting a 10% increase due to market demand, your budget would show an estimated sales figure of $1,100,000.  To put together a proper extrapolation budget, you may need input from departments regarding recent performance. What trends has your sales team noticed? How are unit costs for the most recent period trending compared to the prior period? For instance, has the wholesale cost of the apparel you sell increased, remained flat, or decreased? Building an accurate budget relies on the knowledge each department might have. Keep in mind, if your business is relatively new, it can be difficult to use this budget approach because the business won’t have consistent historical information to base expectations on. But don’t let that stop you from making an educated attempt at formulating a plan.
   

2. Top Down Budgeting  A top down budget method places the budget creation process on your management team. The leaders of your organization will evaluate past trends and develop expectations for the upcoming period based on historical data and other available information. Upper management will usually set the overall budget for each department, leaving the specific allocation of funds to department leads. For example, management might allocate $50,000 to research and development. The department lead will then determine how those funds will be used.
   

3. Bottom Up Budgeting  Bottom up budgeting is the reverse of top down budgeting. In this method, individual team leads will put together a budget to be reviewed and approved by upper management. This can be a better option compared to top down budgeting if you have numerous departments, all with specific needs. For example, your marketing team determines they need $25,000 for advertising, while your administrative department requests $30,000 for a new intern. Each department will submit these costs to upper management. If it is determined that only $50,000 of funds is available to allocate to advertising and an intern, you might decide to cut the advertising budget down to $22,000 and your administrative budget down to $28,000. Each department will then need to adjust its expenditures based on the approved budget amount.

Walking Through a Simple Budget Example

It can be hard to solidify the concepts of budgeting without going through an example. Don’t just skim through the example. Instead, get out a pen and paper, or Excel sheet if you’re comfortable with spreadsheets, and follow along using numbers from your company.

Start With Recent Performance

In the first quarter of the year your business’s profitability was less than expected, primarily due to selling 5,000 units, which was lower than projected. Other key facts to note are that direct materials average out at $45 per unit, while direct labor is $10 per unit. In this case, direct materials and labor are variable costs, meaning the expenses are incurred as the business sells a unit of its product. With this revenue information and your expense data, you generate the following income statement: 

Start with a review of recent financial performance to better understand factors such as the quantity sold, the cost of selling the quantity sold, and how profitable the business was after paying fixed expenses (general, administrative, and selling).

Then Determine Goals For The Upcoming Period

When planning for the upcoming period, you have the following goals in mind: 

• Sell 6,000 units.

• Rework advertising expenditures to be under $20,000.

• Hire a part-time employee with a fixed salary of $7,000 for the quarter. 

• Negotiate new term loan rates to lower interest expense by 10%. 

• You aren’t expecting insurance or any of the other general expenses to change dramatically. 

• No scrap inventory or assets will be sold during the period. 

Keeping these factors in mind, your budget would look like the following: 

When preparing a forecast, first think through realistic sales targets based on recent trends, then consider the variable costs (materials, labor, etc) required to support the sales increase, and also consider which fixed expenses may be introduced in the upcoming quarter.

Next, Fine Tune the Budget To Reflect Desired But Realistic Outcomes

You are disappointed because you were looking to generate $100,000 in profit, but your budget shows $80,000 of profit. To accomplish the $100,000 profit target, rather than cutting expenses you desire to adjust activities such that you can generate more revenue to reach your desired level of net income. By changing your gross sales assumption from 6,000 units to 6,500 units, you notice your profit is just over the $100,000 mark (see figure below).

By increasing the number of units sold from 6,000 to 6,500 you are able to accomplish the goal of generating $100,000 of quarterly income. But remember, activities required to increase revenue come at a cost, so don't neglect the expense associated with driving more sales.

Turning a Budget Into a Plan

For Q2, you’re forecasting the sale of 1,500 more units than you sold in Q1 (5,000 units in Q1 versus 6,500 units in Q2). This is where budgeting transitions to planning and warrants the question: How will you increase unit sales by 1,500?

Perhaps you determine that attending a new trade show will help drive the increase in unit sales, or maybe you, the owner, plan to become more active in sales. Either way, arriving at a strategy that supports the sale of 6,500 units is exactly the point of the budgeting exercise. Don’t forget that increased activities related to selling an incremental 1,500 units will have a cost, and that cost should be included in your budget.

Converting to Monthly Targets

Finally, you want to keep your team motivated from month-to-month, rather than giving a broad quarterly goal. To make the quarter’s goal more manageable, you divide your Q2 adjusted budget into months. For the sake of simplicity, below we’ve divided by three to get a monthly budget for each team member to follow, but if your business has predictable seasonality, or if you plan to ramp sales gradually throughout the quarter, you can adjust the monthly budgets accordingly.

Breaking a quarterly budget down by months can be a helpful way to set more granular goals. This simplified monthly budget divides the quarters by three to arrive at monthly budgets. Each business has unique trends and seasonality, so consider how your business trends from month to month to arrive at a trended monthly budget.

Remember, budgets are meant to be a template to allocate resources for a defined time frame. Setting unrealistic goals can be risky for morale due to the negative impact of missed targets. Or if targets are hit, but the team is burned out due to unsustainable pace, morale can be similarly challenged. Be reasonable and realistic with your expectations and always plan for the unexpected.

Start With Small Steps and Realize Large Benefits

Budgets are important to guide the decision-making process and effectively allocate financial resources in your organization. Regardless of whether you’re planning to exit your business in the near future, or simply want consistent growth, budgets can help you reach desired goals with a disciplined approach to operations.

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