Budgeting is a big part of financial visibility. This is the money you can use. Where is your cash coming from? Are you staying within budget?
These questions are important for the business decisions you need to make, and it’s a common mistake for entrepreneurs to go simply by gut feeling or their grasp of the history of their company. They find it easy to say, “Yeah, I think we’ll be okay if we do this.”
Everything we’ve discussed in these blogs so far should help you switch from using your gut feeling to the practice of management accounting–to actually using accounting to run your business. Bill Sablan of Now CFO gives us insights on the biggest, if not the most important piece of management accounting: your budget.
How to set a budget, according to a CFO
1. Track your variances at least on a monthly basis
Establish your budget thinking forward, not backward.
Many business owners estimate their revenue and total income for the year, then look at their expenses from last year and just copy it forward for the current year. Then they consider what remains as their profit.
It’s a backwards way of running a business, and certainly not the way to set a budget.
You need to monitor your budget to ensure you don’t overspend. You also need to monitor your budget so you can account for any incidentals and variances in your budgeting needs. That’s the only way you can set a proper budget every month.
You’re in business to make money therefore you need to make a certain amount of money for it to make sense for you to continue doing your business.
So, look at profit first. How much money do you need to make for this to be a viable business going forward? How much money do you want to make?
For example, you want to make $100,000 profit for the year.
That then becomes your budget end value.
2. Next, estimate your revenue.
Why is this the next step? Once you estimate your revenue, you can determine your expense budget. This indicates how much money you have to spend for the year.
With that knowledge you can start allocating that bucket of expenses into different departments. That way, you’re actually moving your business forward to where you want it to be, not where to where you think it’ll end up.
3. Create an expense budget.
These three–profit, revenue, expense– are interconnected pieces. Understanding your profit, goal estimated revenue, and what you’ve got left for your expense budget is essential to making sensible, productive financial decisions for your business.
- Have a specific number, for example, $100,000.
- Calculate profit by percentage. ”I have to make at least 20%” or “I want to make 20% on all my revenue.”
Whatever is left is your expense budget. It is easiest to run the calculation in that way–as a simple mathematical formula.
The profit number is personal to you. That’s what you are going to want to make to ensure your business is successful.
The revenue number should be the most up-to-date, accurate information and should impact your expense budget. Let’s say your project you’ll make $600,000 in revenue, if you’re goal is make $100,000 in profit your expense budget is $500,000.
BUT if you end up making only $400,000, and you’ve stuck to your estimated expense budget, you’ll spend too much. You’re losing instead of making money.
That’s why you need to look at the variances on a monthly basis–to see if you’re still on track with your estimates.
How to estimate revenue
Without burying you in finance techniques, there are two types of estimated revenue–rollover revenue and new revenue.
This is determined based on predictions using historical data.
- This examines the clients you have that will still be your clients into the new year
- This also examines clients with consistent bills. For example, in the books, you have a client billed $5,000 a month, or another billed $4000 until June.
- If you have 50 clients, add a row for each one with their respective billings
You can then take your existing customer base and your income from each going forward through the year.
This is where you have to work with your CFO closely.
New revenue is:
- Where you can increase earnings
- Strategies to increase earnings
- What you can expect
Get as accurate a number as you can.
Now, obviously the example above is very simple. It’s a sample, saying you’ll add $5,000 of new client revenue every single month, and it will continue for the whole year.
You can see that these earnings start to compound every single month. In January it’s $25,000 and by December it’s $75,000–all by adding an additional $5,000 every single month.
That’s how you can get your $600,000 estimated revenue.
Really think about where you can source this additional income. You and your CFO can have conversations about things like adding business development personnel who can generate new business for you. How will that affect your budget? Maybe it will take four months to get going.
And then in May, it takes off and you start getting closer to your new revenue goals.
Tailor your revenue budget to the actual financial details of your business. Pay special attention to your unique expenses needed to achieve your goal, and also when the revenue starts coming in. Again, you should do a monthly review of variances.
Like with regard to profit, you can put in a number or a percentage goal, say $50,000 or 10% increase in revenue every month.
Now you have your revenue estimates and profit goal, which determine your expense budget.
How to create an expense budget
Here you see some key expense numbers.
You can start with your historical data. Enter all these numbers. That’s what you spent last year, and it can be your jumping off point for what you’ll spend this year.
You should factor in for your employees. Maybe you’ll hire someone in July, and someone else in October. Add that as well.
After doing so you calculate your total expenses it’s $525,000. You stand to lose $25,000 for the year, or you’d have to take that chunk from the $100,000 profit you wanted to make.
So you start making cuts in your expenses. Maybe you get rid of sponsorships or put off the new hires.
You get closer to your ideal number. You make better decisions. That’s the process. And you don’t set it and forget it.
Remember, you have to monitor the variances every month.
Numbers change, and you could be $8,000 or $9,000 behind in your budget as you go through each month. That’s a problem. You can start evaluating why that has happened.
Perhaps you were expecting $5,000 in new revenue but you didn’t get any new customers and now you’re down $6200.
Now you can start evaluating, why didn’t I get any new customers? Was it the sales expenses, a lack of business development, the marketing?
This is why having a CFO is important
With the added insight from your CFO, you can really start to gain insight into what’s going on within your company.
If you want to hit your goals, you have to know all your relevant financial numbers. Your CFO helps you understand and strategize with those numbers. New revenue can be complicated especially when you add hiring and marketing to your expenses. For every marketing dollar you spend this month, you might not see that revenue until three or four months down the line or even longer!
Again, it’s going to be how you evaluate your business expenses. For example, why did you spend $683 more in marketing than you had budgeted?
Was there something big, a new marketing plan, and perhaps a large, one time expense upfront? Well, okay, that’s reasonable, because now you’re not going to have as big of an expense the next month and it will make up for it in that sense.
You understand that you need to spend a little money up front and revenue will follow. Your revenue will go up, and your expenses might not, unless you hire a new person, or spend beyond your budget in some other way.
It all goes back to financial visibility.
If you only look at your bottom line instead of the whole picture, you might start making bad decisions based on that limited view. This results in both missed opportunities as well as losses as a result of inevitable irresponsible spending.
So, set your budget.
Then monitor it every single month.
Consult and update your cash flow forecast
We’ve talked about the cash flow forecast in the previous blogs. It’s a 13-week forecast, of always knowing your cash position thirteen weeks–or one quarter–ahead of time.
Along with your budget, your cash flow forecast determines how much you CAN spend. It once again has to do with making smart business decisions.
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