Learn Budgeting Basics For Small Businesses

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Source: www.igrad.com

Many business owners run in the other direction when asked to think of a budget. That’s because they think making a budget is a complicated exercise that will require having a financial professional guide you every step of the way.

A budget not only helps in keeping track of your expenses, but it’s a powerful tool that a business has for growing their revenues and profits. A smart business owner should prepare, consult and monitor their budget periodically. All strategic and tactical decisions should essentially come from what your budget looks like.

We have noted some basic concepts that you should think about when making a budget.

  • Make a sales forecast:

If this is your first year in business, it may be difficult for you to forecast sales. But ideally you should be looking at what your previous year sales were, how much marketing expenses will you take in the current year to grow your client base, what are going to be your biggest expenses and so on.

First step is to understand your business model accurately- using numbers. There are multiple ways to categorise where your sales are coming from:

  1. Client Mix: How much sales comes from business and retail customers
  2. Product Mix: How much sales does each product line contribute
  3. Geographical Mix: What is the contribution of different geographies to your sales

Sales-

Product 1 Product 2 Product 3 Total
Customer Type
B2B …. …. …. ….
B2C …. …. …. ….
Geography
Domestic Sales …. …. …. ….
Exports …. …. …. ….

 

Doing this kind of analysis goes a long way in understanding what your business model looks like. And the results may surprise you. If you started out as an export business, and have gradually added domestic sales, it is possible that domestic sales now contribute a huge percentage to your business, but your marketing plan does not account for it.

You can do a second- or third-level analysis depending on the results you see. If exports comprise 90% of your business, you may want to dig further and understand what regions or countries have a high demand for your products.

Export Sales Analysis-

Product 1 Product 2 Product 3 Total
Americas
Canada …. …. …. ….
U.S.A …. …. …. ….
Middle East
Asia – Pacific …. …. …. ….

Once you do this assessment, prepare a similar table, but with forecasted figures for next year. Go as granular as you can. The forecast should capture monthly, quarterly and annual estimates. But do not worry if you cannot make monthly or quarterly forecasts. Stick with what you can reasonably estimate and add details as you get more information from your order books or sales department.

Another important point that people forget is that a budget is just an estimate. It is not set in stone. Depending on several internal and external factors, your actual results in a month or quarter can look vastly different from your budgeted figures. You need to monitor and revise your budget as and when new information is made available to you. A budget is a dynamic tool and you should use it like one.

  • Understand different types of costs:

The second part of the puzzle with any finances is Costs or expenses. There are multiple ways to categorise business costs:

  1. Direct and Indirect Costs
  2. Fixed and Variable Costs
  3. Opportunity and sunk costs

Here’s a handy guide to understand the different types of costs. It is important to get an idea about how much these expenses come out as a % of total expenses. Only once you  know the biggest contributor to your expenses will you be able to reduce or manage these expenses.

When managing about costs, it is good to remember the 80/20 rule. The 80/20 rule implies that 80% of your total costs come from 20% of the categories. For example, you may broadly categorise your costs into Raw material costs, Personnel expenses, Marketing costs, general and administrative costs, and miscellaneous costs. When you study your costs, you may see that 80% of your total costs come from 2 categories – personnel and marketing costs i.e. 20% of your expenses.

It is worthwhile in this scenario to focus your efforts on curbing these costs, instead of saving pennies on some other expense.

  • Cash is key:

Other than knowing where your business stands vis a vis sales and costs, a third important metric to track is the cash flow. Put simply, it is the cash coming in and going out of the business. You need cash to pay salaries, pay off creditors, pay for supplies, meet utility bills, etc. You receive cash when your customers pay you. It is important that you have sufficient cash to meet your requirements. Frequent delays in cash payments result in dissatisfied suppliers, disgruntled employees and bad credit score.

Some best practices to remember when deciding your working capital requirements:

  1. Negotiate good payment terms with suppliers as well as customers. Having good credit terms with suppliers implies that you get to delay paying them for purchases. Good terms with customers means you get paid in advance or immediately upon sale.
  2. Open an overdraw facility with your bank, just in case– Depending on your credit score, you should be able to negotiate a good overdraft facility with your bank. But relying too much on this could mean you end up paying a lot of interest, especially if you do not keep a tight grip on your expenses every month.
  3. Keep aside some cash for contingencies. Expenses happen. Machines break down. Your supplier increases price unexpectedly. Marketing costs increase. You cannot plan for everything. And this is why it is prudent to keep aside some percentage every month to ride out these expenses.
  • Profitability:

Profit is what makes or breaks a business. Scaling operations is important, but not at the cost of your profitability. When adding new products or new customers, it is imperative to perform a profitability check. Put simply, you should be asking yourself if adding a new customer or product is worth the effort?

Making 10% or 20% net profit may work for a huge corporation operating in billions, but if your revenues are low, then in real terms the amount of profit that you make, may not make sense for you.

You should always be working to improve your profitability:

  1. Make a plan for reducing costs – Should you automate or hire more workers? Is it better to manufacture or outsource? Rent or own? These are financial decisions that can have a big impact on your profitability. And these are not one-time decisions. Maybe it made sense to own your office space 10 years back. Depending on market conditions, it may be better to rent now. Have a system in place to review these decisions periodically.
  2. Prepare a marketing plan – You cannot afford to be whimsical when deciding what expenses to undertake. Marketing requires some experimentation, but it cannot be a reckless one. Make a marketing plan at the beginning of the year, make an estimate of how much you are willing to spend in exchange for how much growth. Strategic thinking is important if you want to maximise your ROI on your marketing efforts.
  • Know your break-even numbers:

Knowing your breakeven numbers is pivotal if you want to build a sustainable business without losing your money. Break-even is the minimum amount of sales (in units or value) you should have to avoid incurring losses. Anything over and above the break-even number goes towards your profit.

To calculate your break-even point, you first need to categorise costs into Fixed Costs (whatever you incur regardless of sales) and Variable Costs (that rise directly in proportion to sales).

Break-even Point = Fixed Cost / (Selling price per unit – Variable Costs per unit)

Break-even numbers also help you price your product or service right. You can think of scale pricing if an order promises to cover your break-even number quickly. Even if you make lower profit on incremental sales, you can at least be sure that this sale directly adds to your pocket.

What now?

These concepts are just the basics if you are getting started with making a budget or are just scared to deal with numbers. You can add more level of detail depending on your business and growth plans. Either way, you cannot afford to not have a budget if you want to grow a profitable business.

Author | Prerna Sharma