By Ian Kelly
In this article, ‘budget’ and ‘plan’ are virtually inter-changeable. Indeed, in some countries, a budget is called a plan.
1. View the budget as a management tool
The budget is a powerful tool. It …
• reflects top management’s goals while providing the wherewithal for lower-level managers to achieve the goals
• gives formal structure to — and communicates – management’s business and operational plans
• determines allocation of resources throughout the company and sets out management’s expectations for department heads and employees.
Management can monitor actual results against the budgeted numbers and use the analyses to make key decisions.
2. Start with a plan
State your assumptions. Use detailed goals for the organization and a plan for achieving them, including objectives (i.e. sales volume, market share, production quality, etc.), and key steps needed to achieve them. Then express the plan in formal quantitative terms — a budget.
3. Use the prior period’s expenses as a starting point
Think of budgeting as a continuous, iterative process. Examine the previous period’s budget and actual expenses as a guide. That will help you identify expenses not yet incurred and those you may encounter in the future. Analyze prior figures with an eye toward trends (e.g. steady increases in electricity costs), and relationships that may exist between costs and profit levels.
4. Keep the process a series of two-way exchanges
Remember that an effective budget depends on the quality of information supplied, and in turn on the quality of information you request. Top managers may request too much or too little funding, over- or underestimating the company’s potential. Seek input from department heads and others who know the day-to-day operation of the business. Keep up to date on the current potential of the business in all areas of operation.
Help junior managers feel confident by guiding them toward attainable goals and remind everyone that setting unrealistically low income or profit goals may produce inefficiencies and waste.
5. Ask a financial professional to review the plan/budget
Depending on your background in finance, you may want to ask a full-time accountant or finance professional to review the budget you create. The contribution will provide an independent review of your financial plan and help you produce a plan that is both feasible and accurate.
6. Prepare both a short- and long-term plan/budget
Prepare a short range, month-to-month plan for at least a twelve-month period, and a quarter-to-quarter long-range plan for three to five years out. Allow sufficient time to gather information (two months should be enough) before you begin work on the yearly budget. How often should you revise the budget? That depends on the nature of your business and the actuals as compared to the budget.
7. Use broad categories to identify expenses
To create a clear picture of expenses, make categories of expenses first and then focus on the line items in each group.
For example, over the course of a year your business will probably have recurring expenses and one-time expenses. Make broad categories for sales, materials or inventory, labor, overhead, marketing and advertising and administrative expenses. Then check each against the other to ensure your estimates fit together. For example, correct for an inventory level that requires twice the labor budgeted. Do this either by lowering the anticipated inventory or raising the figures on labor required. The categories you choose will depend on the way you view the business and assess results.
8. Build in a safety margin
Make sure the budget includes funds reserved for emergencies. This is vital. You must ensure sufficient cash on hand to handle unexpected costs such as uninsured damage to plant and equipment or excessive employee turnover. Reserve roughly ten per-cent of anticipated earnings for unexpected expense.
9. Make a priority list of expenses
If you’re short on cash, which expenses do you delay? To decide, prioritize expenses based on what is essential to the operation of the business. For example you might delay remodeling or new employee uniforms but not delay replacing damaged production machinery. Prioritizing expenses before you draft the budget allows you to create scenarios – and the risks and benefits associated with each.
10. Keep in mind the cost of capital
When borrowing funds, returns on the money should be at least equivalent to the rate you must pay your creditors. Keep this in mind when assessing terms of the loan and when deciding how to use the borrowed money. For tangible expenses such as plant and equipment purchases, the calculation is more straightforward than with intangibles such as employee training, and marketing and advertising.