Updated: Jan 25
Do I really need a budget? The short answer is YES! As we mentioned in the first article of this series, a budget should be developed as a prerequisite for starting a business. Why? If for nothing else, it serves as reality barometer for the prospective entrepreneur. Budgets are typically developed on an annual basis (at a minimum) with monthly or quarterly intervals. Below are five reasons budgets are critical to any business:
1. Serves as a Financial Score Card
Developing an exact budget provides the entrepreneur with the means to decide if launching this business is risk worthy or not. If the entrepreneur accepts these risks, the budget serves as a financial score card, whereby the owner can measure actual performance against it on a monthly basis. To the extent there are significant variances; one can dig into the accounting system to determine why. There are typically three reasons for significant variances between actual and budget:
Timing – An item is budgeted to occur in one month, yet actually is recorded in another month.
Mistake – An item was either missed when budgeting or, conversely, was included in the budget originally, but shouldn’t have been.
Change – For a new organization, this is a biggie. Often, the scope and business model will go through some changes based on the realities of the market. Where we originally determined to sell one item at one price point across several channels, we had to change to a multi-tier pricing model across fewer channels.
Budgets are never perfect, especially the first few times. They are created to provide a reasonably accurate forecast of the future given certain parameters. When those parameters change, using the budget as a financial score card gives you the means to understand just why the financial results were different and also allows you to modify the budget as necessary to reflect these new realities. With time, experience and stability of your business environment, these forecasts and budgets will improve in their veracity.
2. Identifies Required Assets and Associated Liabilities
When budgeting, there are a number of questions that need to be answered. One of the critical questions is: What assets are required to allow you to run and grow the business over the next 12 – 18 months? Do you require warehousing space? If so, do you own the space? If not, how much will it cost to lease the required space? Have you considered what equipment is required? Will I need to borrow to cover the costs? These questions identify what assets are required and the costs and the likely terms involved to acquire them. Additionally, as many of these assets are capitalized, the costs are typically only partially deductible in the year of purchase through depreciation. This is a key area that can often times be overlooked, often to the business owner’s dismay come the close of the year when paying taxes.
3. Identifies Revenue Drivers and Dependencies
A good budget process digs down to the nitty-gritty. It identifies what products/services are to be sold and at what prices. This could involve multi-tiered pricing models and a number of channels, but it is critical to get your arms around the numbers here as they drive the revenue reported in the budget. They also serve as the means to understand what is necessary to produce these products or services. It will tell you what is the necessary capacity required to fill the order. What man hours are required? What materials? It is here that the cost of sales are determined for the budget. Once the revenue and cost of sales has been determined, you will be able to calculate the gross margin. The gross margin is used to cover the expenses of the business not directly related to the production of goods or services.
4. Identifies Fixed and Variable Expenses
Expenses come in two varieties: Variable and Fixed. Variable expenses change dependent upon growth of the organization, typically dependent upon sales volume or personnel numbers. Payroll, payroll taxes, training and office expenses are some costs that are considered variable. Fixed costs are those which only change due to inflationary or physical changes. Property taxes and utilities would be considered fixed costs. Identifying these expenses and accurately laying them out in a budget really help a new business owner understand their costs in running the business. Don’t underestimate this!
5. It Helps Predict Cash Flow Ups and Downs
Taking the components above and combining them into a budget, also provides a cash flow forecast. This forecast will reflect any seasonality in the revenue, cost and expenses and will also show the impact of cash purchases or lending as they come about. The cash flow forecast will show where there is a likelihood that additional cash will be required to float through a negative cash flow month or quarter. Wouldn’t you like to know that before you start or be surprised when it happens? It pays to know. You can reformulate a game plan to address these issues, when they are known in advance.
So is a budget really necessary? It certainly is, if you take your business seriously. Budgeting is a vital tool to have in your tool belt as you begin this journey of entrepreneurship! If you have questions or comments on this article, I welcome the feedback. Comment on our Facebook page. If you’d like to set up an appointment to talk to us, click on this link.
Just a reminder; the next article in the Where Do I Start? series addresses the question of How Do I set Up My Business?