What is a budget, why should I bother?

My accountant and my bank manager have suggested that I should have a budget for my business. I am not sure in practical terms what this means, but it does sound like more useless paperwork. So tell me please, what is a budget and why should I bother - I always end up making a profit and my accounts go in on time?

Firstly the fact that your accounts are produced at the end of the financial year has no bearing on this. The final accounts are a record of past achievement and are too historical to use to control the business. That the business “ends up making a profit” is good news, but profitable businesses fail all of the time - often when sales are increasing - because they run out of money to pay what they owe. This is often avoidable through good financial planning & control; having a budget is central to this.
Not that fear of failure should be the main motivation for having a financial plan, you should develop a financial planning and control process in order to grow the business and achieve your goals.

 

But the terminology can be very confusing and off-putting

Let's deal with the terminology first. Financial plans, forecasts budgets and targets are often interchangeable terms, and budgets in one business are financial plans in another. You may have done a cashflow forecast when you first started the business, if so that was your first financial plan within which you would (knowingly or unknowingly) have set targets for sales, purchases and individual elements of overhead cost.
Costs can be direct or indirect - direct costs are incurred as a result of sales activity such as manufacturing and purchasing costs; indirect costs are costs that you will have to incur regardless of whether you make or sell an item or not, overhead expenses such as rent, stationary, admin staff wages come under this category.
Costs will also be fixed or variable or a mix of both like the telephone with its fixed rental and variable call costs. However, what is important for our purposes here is to identify the important and significant costs that are under your control. For instance rent and business rates are significant costs, but once they are set there is not much you can do about them other than making sure that you have the money in the bank to pay for them. On the other hand, costs of manufacturing and power usage can be controlled through good procurement and waste reduction, so these and other controllable costs need to be looked at carefully.
Profit can also be confusing; the three main terms used are gross, operating and net profit. Gross profit is the difference between sales and the cost of sales, operating profit (sometimes called trading profit) is gross profit less marketing and admin (or overhead) expenses, whereas net profit is calculated after interest and any exceptional incomes or costs, and can be called net profit before tax or after tax. Just to further confuse matters we often substitute the word margin for profit so that gross margin means the same as gross profit.

So what is a budget?

Budgeting at its simplest is to pick a number and decide what you want to sell or spend each month then measure your performance against it for the coming year. That piecemeal approach is ok if you are planning a holiday or arranging a car boot sale (perhaps to pay for the holiday), but in business you need to look at the wider picture, rather than pluck a few figures randomly out of the air.
A full budgeting process would forecast the amount of cash coming into and going out of the bank every month, the amount of gross and operating profit being made each month (and yes there is a difference, often a large one, between profit and cash in the bank) and a forecast of the balance sheet. This is only the start, the other and possibly most important part is measuring actual performance against the budgets regularly - say monthly. Then making timely decisions, and taking positive action to improve business performance if you are failing to meet your budgets on the important things that you have chosen to measure, and that are within your control.
The shape, size and complexity of your budgeting process should depend on your needs and resources. For instance you could spend a long time and a lot of money developing a complex set of forecasts measuring everything, but have neither the time nor the expertise to produce the monthly actual results or to make any decisions based on those results.

So where do I start?

Simple but effective is the key. Let's be clear, the purpose of the exercise is to have a process or system in place which allows you to have a realistic expectation about the performance of your business, a means of measuring the actual performance against your expectation (budget) and taking corrective action to get back on track if need be. Therefore this is a means to an end and not something to be done at the beginning of the year and forgotten about; so it needs to be manageable as well as meaningful.
In next month's newsletter we will look at the rules for putting together a simple cash budget, some thoughts on extracting the important things to review regularly and then look at the 'so what?' question i.e. what to do once you have measured them.

That's all for this month.

Peter Mulhall
Business Adviser
tel: 07717 290309

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