In its purest form, a budget is an estimation of revenue and expenses over a specified future period of time. Budgets can be made for individuals, a family, a business, a government, a country, or about anything that makes and spends money. For organizations created to make money, a budget is an internal tool that should be used by management to evaluate the overall financial success of the organization for that specified period of time.
An effective budget is compiled and re-evaluated on a periodic basis, generally monthly, and compares the budgeted revenue and expenses with the actual overall results. I never cease to be amazed at how many business owners spend more time planning their annual vacation than they spend developing an annual budget, much less reviewing this budget with how their company performed. They’re often intimidated by the process, and rather than diving deeper to help them create more wealth and greater success, they set it aside as a future project that never materializes.
Without an annual budget, it will be more difficult to evaluate your business and its financial performance. The budget gives you a financial roadmap and allows you to compare your actual results to the forecasted results throughout the year and make any necessary adjustments: This is how we thought we performed. This is how we actually performed. Now let’s analyze the variances and determine why.
How to Create Your Budget
Begin the budgeting process by studying your income statement from the previous year line by line. Look for anomalies, non-recurring one-time purchases or areas where you feel you over- or under-spent for the previous year. After this analysis, assess how well you performed from an income statement perspective that year. With that information, you can create an annual budget for the next year that includes sales projections.
For example, if your business produced a $500,000 profit in 2019, and you know there were $50,000 in one-time expenses that won’t be repeated in 2020, you should expect, all things being equal, a profit of $550,000 in 2020. That is an over-simplification, but it is an effective starting point for creating your in-depth budget.
Secondly, understand the seasonality of your business model. A landscaper in Ohio is certainly going to have much more seasonality impacting his monthly revenues and expenses than a restaurant in Nebraska. Accounting for these nuances will make the budget more meaningful, effective, and realistic.
In my past life as a CPA, I assisted many clients with their budgetary process. Generally speaking, the clients were better at evaluating expenses than they were at estimating their future income. Typically, they looked at the expenses, made adjustments up or down, and then either consciously or subconsciously said to themselves: “What amount of revenue do I need to cover those expenses and make the profit I want for the year?” This couldn’t be a worse idea.
The revenue and expense budget must be realistic and achievable. It’s fine to have stretch revenue goals but use it as a sanity check, too. Compare your budget’s growth to your history and your industry’s growth. If your industry is growing at 20 percent annually and you’re projecting less, ask yourself and understand why. Conversely, if your industry is regressing and you think your business will be up 10 percent, make sure you aren’t set unrealistic expectations.
Evaluate Throughout the Year
Once you’ve created an in-depth budget, adjusted it for seasonality, and allocated it on a monthly basis, use it as the financial scoreboard for your business throughout the year. Evaluate the actual results each month against your budget to assess how your business performed compared to what you expected. Comparing actual results against your financial forecast allows you to make forward-thinking decisions without second-guessing. You wouldn’t play golf without looking at your scorecard or go to a basketball game without looking at the scoreboard, so why would you ignore your budget throughout the year?
Management must evaluate the differences between the budget (your forecasted earnings) and the profit and loss statement (your actual earnings) to determine if any changes are needed in the business based upon specific variances. If you can’t make time to evaluate it monthly, at least do an intimate review of your income statement monthly and make a budget comparison quarterly. The more effort you put into comparing the actual results versus your budget, the greater the likelihood of success.
Your budget is similar to a weight-loss strategy. Saying you want to lose weight isn’t a plan or a strategy. Without a plan, you probably won’t lose any weight even if you want to. If you say you want to lose 20 pounds by mid-year, you now have a specific goal and can put a dietary and exercise plan in place to get there. Your goal weight is your budget, and weighing yourself regularly to evaluate your progress is like comparing your actual results to your budget throughout the year.
Finally, use your budget to decide if your business plan needs to change. You may think you know how your business is doing, but until you evaluate your results against what you expected, you can’t be sure. A budget can help you evaluate your successes or failures and make any necessary adjustments.
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